Financing a U.S. Subsidiary: Debt vs. Equity

Canadian corporations seeking to expand their operations often look southward to grow their business. By expanding into the United States, Canadian corporations can potentially gain access to a much larger market than is available in Canada. For a variety of valid reasons, Canadian corporations often choose a U.S. corporation as a vehicle for expansion into the U.S. But once this structural decision is made, the question becomes, how to finance the U.S. operations? 

New U.S. businesses often face a lack of U.S. external funding options. Consequently, such U.S. corporate operations are often financed internally with equity, or through either advances or non-interest bearing loans from the Canadian parent corporation to the U.S. subsidiary (or a combination of equity, loans and advances). From a Canadian tax perspective, this tendency should not be problematic. However, from a U.S. income tax perspective, the use of non-interest bearing loans may create issues that are both costly and time-consuming to resolve.

Characterization of debt and equity: the issue

Under U.S. federal tax legislation, the Internal Revenue Service (IRS) has the authority to recharacterize debt as equity and equity as debt, or a combination of the two. Yet the holder of the interest in the U.S. corporation is bound by its own classification of the investment.

The IRS’ ability to recharacterize the investment in the U.S. corporation can create unintended consequences for the taxpayer. For example, assume that the Canadian parent would prefer to treat the investment as a loan to the U.S. subsidiary. This strategy would allow the U.S. subsidiary to reduce its U.S. taxable income by claiming an interest deduction for the interest expense paid to the Canadian parent. Generally, claiming a deduction in the U.S. corporation should reduce the overall tax rate of the related companies, as the U.S. federal and state tax rates generally are higher than the tax rates in Canada. If the IRS disagrees that the investment in the U.S. subsidiary is a loan, then it would treat the investment as an equity investment. Payments that were made to the Canadian parent corporation would be treated as equity distributions, which might be considered as dividends (to the extent of earnings and profits within the U.S. subsidiary). If the payments were treated as dividends, the U.S. subsidiary would be required to withhold and remit 5% of the dividend to the IRS and fulfill the reporting requirements related to the dividend payments. Some of the implications of this change in treatment include:

1. denial of the interest deduction by the U.S. subsidiary, resulting in a higher taxable income and potential tax owing;
2. late payment and estimated tax penalties as a result of the larger tax liability;
3. failure to file and failure to pay penalties on dividends paid to the Canadian parent; and
4. potential substantial understatement penalties.

In order to avoid this possible situation, the corporate taxpayer should reflect the investment on the subsidiary’s books in the manner that it intends to treat the investment. It should ensure that the income tax filings and other reporting requirements reflect a treatment consistent with how the taxpayer wants to treat the investment. 

Criteria for characterization as debt

Initially, with its authority to recharacterize debt and equity, the IRS had issued regulations setting out the criteria to be used to determine when it would treat an investment as debt. These regulations were never finalized, however, leading to a lack of guidance from the IRS. Over the years, the courts have tried to establish criteria to determine when an investment will be treated as debt or equity. However, again, due to the variety of investment structures and financing options available in the market, a clear definition of what is debt and the criteria needed for an investment to be treated as debt, have not been set out clearly. It is very much a “facts and circumstances” analysis specific to a particular situation. The following criteria will be relevant:

• An instrument labelled as a note is more likely to be considered to represent debt, provided it has the terms that a third party lender would include, such as a fixed term, an interest rate, a repayment schedule, etc.
• If repayments are primarily tied to the ability to generate earnings, an equity classification is more probable.
• The ability to demand repayment of advanced funds indicates a debt instrument.
• The ability to participate in management might indicate equity.
• Advances subordinate to other corporate loans are closer to the equity classification.
• The intent of the parties should be considered.
• The debt-equity ratio of the company should be considered.
• An instrument that allows interest payments to be dependent primarily upon the availability of future earnings (i.e. dividend money) is more likely to be considered equity.
• Evidence that a corporation could receive financing from other third-party lenders increases the chance that an instrument will be classified as debt.

Generally speaking, at a minimum, if a taxpayer desires debt treatment it should ensure that it has a written agreement in place that contains all of the conditions that a bank would require to support debt treatment. These would include, among other things, a fixed loan term, a stated rate of interest, and a repayment schedule. Furthermore, it should ensure that the terms of the agreement are complied with – that is, the terms of the agreement are actually followed and reflected in the corporate documents and accounting records of the corporation.

Summary

The IRS is searching for opportunities to generate revenues for the U.S. government. It is becoming more aggressive in attacking situations where it may perceive the lack of a clear treatment of an item, and specifically in regard to situations – such as the debt-equity treatment – where it has the latitude to treat the item as it wishes. To the extent taxpayers can remove any potential ambiguity in their accounting records and related tax returns, this can minimize the chance that the IRS will identify potential issues to attack.

This article addresses a specific area of concern, but it does not address the circumstances under which debt or equity is preferable, the rules to deduct interest in the U.S., or other financing or structural issues. Contact your Collins Barrow adviser for more information on how to structure and finance your U.S. operations and any other U.S. tax matters.

Mark Ball, CPA, MST, is a Tax Partner in the Calgary office of Collins Barrow.