More Debt/Equity Challenges

By James J. Tobin, Esq.  

Ernst & Young LLP, New York, NY

 

Global tax controversy continues to escalate, which is not surprising given the increasing need for tax revenue around the world. Our surveys of tax directors demonstrate across the board that there is an ever-increasing focus of both internal and external resources on tax controversy. After transfer pricing, the area where I'm seeing the most activity, in more and more countries, is the range of issues involving debt/equity questions, particularly the deductibility of interest on internal or intercompany debt. Challenges are being brought by tax authorities based on the purpose, magnitude, and nature of intercompany debt, as well as the quantum of interest and other finance charges related to the debt. It's a good time for all multinational companies to review their worldwide intragroup borrowing arrangements and ensure that their arrangements are consistent with arm's-length terms and their documentation is well prepared and up to date.

I find that the practical issues in evaluating intragroup debt arrangements are in many ways similar to transfer pricing issues. I've written previously that for a typical MNC, intercompany pricing that reflects local country individual legal entity profitability is often of importance only to the tax department and possibly the legal and accounting groups. Operational management typically runs the business on a global or regional basis by product line or division and often cares not a hoot how transactions that are purely intragroup are priced. Establishing arm's-length pricing is a cumbersome process that can lead to much debate between tax authorities and taxpayers.  (Hence the increasing desirability of Advance Pricing Agreements and other means of achieving advance agreement on such issues.)

When it comes to the setting of intragroup debt/equity levels and terms, operational management of MNCs usually is similarly indifferent. The measurement of business unit results typically would be at an EBITDA (earnings before interest, taxes, depreciation, and amortization) or gross margin level, which means that even group-wide finance costs would not be considered. But, unlike in the case of intragroup product or services flows, there is another important management party who usually is very interested in matters relating to intragroup finance flows: the treasurer and/or CFO. And the natural preferences of the treasury department would typically be at odds with the objectives of the tax department.

My observation is that a typical corporate treasury strategy would be to centralize external debt at the headquarters level in order to achieve the best access to the capital markets and to concentrate banking relationships. The typical strategy also would be aimed at having full unrestricted access to all assets and cash flow of the group globally in order to obtain the best credit rating for the group. This could be achieved either by group-wide guarantees or by maximum intragroup debt levels to ensure access to cash from subsidiaries with minimum local law restrictions on the distribution of assets and earnings. All of this treasury strategy has significant tax implications, most not good. Obviously the remittance of subsidiary earnings back to the parent often is costly from a tax standpoint, particularly for a U.S. MNC. Worldwide guarantees would create deemed remittances under §956 for a U.S. MNC. And a prejudice toward debt funding, rather than capitalization, of foreign subsidiaries of U.S. MNCs results in the high U.S. tax rate being imposed on interest income and interest expense being incurred in a lower foreign tax rate jurisdiction, with the worst case potential for the interest expense to produce no foreign tax benefit due to local losses or local limitations on debt levels or interest expense deductions. Moreover, this kind of debt funding approach is rife with tax exposures in the foreign exchange area.

From a tax perspective alone, the typical objectives in the corporate treasury area would be to fund low-tax subsidiaries with equity and to defer repatriation and perhaps to fund high-tax subsidiaries with debt to the extent allowable - although for U.S. MNCs there are not many countries that are relatively high-tax. In addition, the tax strategy of U.S. MNCs typically would be, where possible, to use a foreign finance company to facilitate equity funding from the United States, maintenance of appropriate debt levels in the foreign subsidiaries, and coordinated cash and treasury management within the foreign subsidiary group.

This tax optimal paradigm doesn't jive well with the treasury optimal paradigm. So there often are battle lines drawn between tax and treasury. Traditionally, tax inefficiencies were usually viewed as more significant than treasury constraints.  However, given the current challenging global economic conditions, such is not always the case today.

As noted at the outset of this commentary, today MNCs often also face battle lines that are drawn by tax authorities.  The choice of debt versus equity for subsidiary operations of MNCs remains one of the most significant tax planning tools available.  Given the increased aggressiveness of tax authorities as well as the escalating focus on the possibility of "inappropriate" tax planning and rising concern about the potential for "double non-taxation,"2 it is prudent to step back and ask whether traditional cross-border group finance planning is at risk or at least in need of careful re-review. I would submit that the latter is indeed the case.

In considering policy perspectives with respect to intragroup financing some recent U.S. developments have me somewhat encouraged about the ability of taxpayers to continue to rely on conventional tax principles and precedents in their planning analysis. Regular readers of this commentary know that I am an optimistic - if sometimes paranoid - guy and this time my optimism stems from two significant U.S. tax cases in the debt/equity area which were both decided in 2012. One case dealt with debt structured into the United States by a foreign parent company - the Scottish Power case3 - and the other dealt with an outbound financing arrangement by a U.S. group - the PepsiCo case.4

Both cases involved intragroup financing arrangements.  Both were hybrid financing arrangements designed to produce current interest deductions in the borrowing country and no current tax costs in the lending country. And both were decided by the court in favor of the taxpayers based on a thorough and balanced analysis of the traditional U.S. case law precedents dealing with distinguishing debt from equity without regard to the treatment of the arrangement in the counterpart jurisdiction. These cases have been the focus of numerous articles, so I will be brief in highlighting a couple of interesting aspects of each.

The Scottish Power case involved the financing of what was otherwise a share-for-share acquisition of Pacific Corp, with intragroup lending made to a reverse hybrid U.S. partnership that was treated as a corporation for U.S. tax purposes and that was the parent of the acquiring U.S. consolidated group.  This structure predated the anti-abuse rule in Regs. §1.894-1(d) and at the time resulted in a U.S. interest deduction and essentially tax-free treatment in the United Kingdom (through the use of foreign tax credits there). The debt level was set at a three-to-one debt/equity ratio based on the Pacific Corp purchase price and the debt was divided into two tranches: one for $4 billion, with a fixed interest rate, and the other for about $900 million, with a floating interest rate and a longer maturity date. Presumably the use of the second tranche was at least in part a risk mitigation strategy due to the approach of the §385 rules, which requires an all or nothing - either debt or equity - analysis of each instrument.

The facts presented in the Scottish Power case revealed that the subsequent operation of the business proved with hindsight that the debt levels originally established could not be sustained. As a result, after several years, part of the debt was converted to equity and, when the anti-abuse rule included in the §894 regulations took effect, the remaining debt was converted from the original reverse hybrid structure to another form of borrowing. Also the borrower did not timely pay its interest obligation in the first year of operation due to regulatory restrictions on operating company dividends. But such outstanding interest was satisfied shortly thereafter, and subsequently interest was paid timely.

The court's analysis in Scottish Power was done on a pure debt-versus-equity basis, analyzing historical case law precedents. The court analyzed 11 factors for assessing debt/equity treatment, citing the Ninth Circuit Court of Appeals case Hardman v. U.S.5 The court also cited the Laidlaw case6 (one of the IRS's successful cases in this area) in its analysis. The court was not influenced by the hybrid nature of the financing arrangement.  In fact, the court specifically rejected the IRS argument that the tax avoidance motives present were an indication that the advance was really equity, stating that a desire to minimize tax is not conclusive as to the character of an advance and pointing out that tax considerations naturally permeate the decision to capitalize a business with debt or equity.

The 11 factors considered and the court's finding with respect to each factor as to whether it was more debt or equity flavored in the financing arrangement at issue in the case are as follows:

 

Court View  

1. Document Labels

Supports Debt

2. Fixed Maturity Date

Supports Debt

3. Source of Payments

Supports Debt

4. Enforceability

Supports Debt

5. Participation in Management

Neutral

6. Creditor Status / Subordination

Supports Debt

7. Parties' Intent

Supports Debt

8. Thin Capitalization

Supports Debt

9. Identity of Interest with Shareholders

Supports Equity

10. Payment of Interest out of Dividends

Supports Debt

11. Ability to Obtain Loans from Third Parties

Supports Debt for Tranche 1, Neutral for Tranche 2

Overall, there was a clear predominance of factors supporting the court's conclusion that the arrangement was debt.  But the analysis of these factors does seem necessarily to have a good bit of subjectivity in it. I re-read the Laidlaw opinion as well, in which the court found a predominance of equity factors, and was struck by the fact that, in some respects, the court decisions seem to demonstrate a results-orientation to the analysis. In this regard, I found several aspects of the Scottish Power court's 11-factor analysis to be particularly interesting:

  The court did not view the first year late payment of interest and the lack of pursuit of creditor rights for this act of default as very damaging. The fact that ultimately all interest was paid was viewed as more important.

  The loan instruments did not contain all the customary protective covenants.  For example, the loan documents did not contain protection for the lender from the U.S. borrower taking on significant senior debt which would effectively subordinate its rights. The court was of the view that certain creditor protections were not as important in a related-party context, given that the parent's 100% ownership interest effectively could protect against such subordination type actions. This seems to me to be a sensible approach and avoids the need to "over lawyer" internal group agreements.

  With respect to the overall debt-to-equity level of the borrower and whether similar debt could have been raised from unrelated parties, the court also took a somewhat relaxed approach. The government's experts questioned whether this level of third-party debt could be raised and concluded that, even if it could have been raised, the equivalent S&P rating would have been below investment grade.  The taxpayer's experts also acknowledged that, while the debt could have been issued to third parties, the required interest rate likely would have been higher, the indicative rating lower, and the second tranche potentially would have required subordination. The court, nonetheless, concluded that these factors favored debt treatment, stating that "the requirement for precise matching (of terms) misses the mark." The fact that instruments likely could have been issued to third parties, albeit at a higher interest rate, was sufficient to satisfy the debt-like standard. This also seems to me to be a sensible approach. It wouldn't seem reasonable to treat the possible under-charging of interest expense as a penalty that could affect the characterization of the instrument.

Now let's move on to the PepsiCo case, that also addressed some interesting features and contained some notable holdings. The PepsiCo case involved the classification of "advance agreements" made from a U.S. shareholder to a Dutch subsidiary. The advances were held to be debt for Dutch tax purposes, with corresponding accrued interest expense deductions in the Netherlands, and were considered by PepsiCo to be equity for U.S. tax purposes such that any "interest" payments would be considered dividends or return of capital distributions for U.S. tax purposes. The court again held in favor of the taxpayer, in this case accepting equity treatment for U.S. tax purposes. Its analysis was, like the opinion in the Scottish Power opinion, based solely on traditional case law debt/equity factors, which in this case were the following 13 factors set forth in the Mixon case:7

 

Court View  

1. Document Labels

Neutral

2. Fixed Maturity Date

Supports Equity

3. Source of Payments

Supports Debt

4. Enforceability

Supports Equity

5. Participation in Management

Neutral

6. Creditor Status/Subordination

Supports Equity

7. Parties' Intent

Supports Equity

8. Identity of Interest with Shareholders

Neutral

9. Thin Capitalization

Supports Equity

10. Ability to Obtain Loans from Third Parties

Supports Equity

11. Use of Advances

Supports Debt

12. Failure to Repay

Neutral

13. Risk

Supports Equity

Clearly, a strong majority of factors were viewed as favoring equity treatment, which was the holding of the court in the PepsiCo case. The most influential factors included a very high debt-to-equity ratio, the long and potentially perpetual term of the advance, a lack of normal creditor protections which meant that the subsidiary could issue an unlimited amount of senior debt, and the overall intent of the parties to treat the advance as equity from a U.S. tax standpoint. As in the Scottish Power case, the hybrid nature of the instrument (and the resulting availability of interest deductions in the Netherlands) was not an influencing factor in the court's analysis nor was the intent of the parties to treat the advance as debt for Dutch tax and legal purposes. The court's view of the significance of the lack of creditor protection covenants, which lack allowed the subsidiary the potential to issue senior debt, was interesting given that the Scottish Power court gave much less weight to a lack of some similar typical creditor protection covenants. As with the Scottish Power decision, I sense some of the conclusions on individual factors were, to some degree, driven by the court's overall assessment in favor of equity treatment.

Is there an overall theme or learning that can be deduced from reviewing the recent cases and the increasing global controversy activity in this area? One clear conclusion is that the level of attention that needs to be paid to this area in terms of analysis and careful documentation is higher than it ever has been and continues to increase. To me, the most important things for companies to focus on are as follows:

  •   Ensure that the debt level established is reasonable and can be benchmarked/documented as a quantum of debt that would be reasonable/achievable in a third-party context. As I indicated upfront, I believe these documentation requirements can be satisfied through a transfer pricing type approach that looks to third-party-equivalent debt levels and interest rate supporting data. In my view, the results of this third-party comparable analysis should be considered something of a super factor in any debt/equity analysis.
  •   Reasonably document the terms of the lending arrangement in a commercial way. I don't think companies or tax authorities should get too hung up on insisting on the minutiae of every conceivable commercial covenant that the most conservative lender's lawyer could construct in a third-party arrangement. I like the approach of the Scottish Power court in viewing a covenant-light arrangement as acceptable in a related-party context. However, the authority on how detailed the legal agreements need to be is less than clear, so I would approach this area with some caution as well.
  •   Then carefully live by the terms of the loan agreement - make interest and principal payments when due, live with and document compliance with the terms of any covenants, and do not take actions detrimental to related-party creditors, whether legally restricted by covenants or not.

 

These steps, in my view, should all help ensure debt treatment in the United States or in other countries if that's the intended result. And, as I noted upfront, the intended result is often more driven by treasury objectives than tax considerations.  But these days getting the desired character treatment for tax purposes is just the starting point. Debt characterization merely gets you in the game. Because then you have to deal with all of the other restrictions on interest deductibility around the world, such as §163(j) in the United States, the similar 30% of adjusted income limitation in a number of countries, including Germany and Italy, the U.K. worldwide debt limitation, the recent French arbitrary disallowance of 25% of interest expense, and the Canadian foreign affiliate dumping rules - many of which are new or newly enhanced regimes that I have commented upon disapprovingly in prior commentaries.8 So while the recent U.S. case law on debt/equity characterization is encouraging, taxpayers are facing more and higher hurdles on the way to the finish line of the sustaining the expected tax treatment of their cross-boarder financing arrangements.

This commentary also will appear in the March 2013 issue of the  Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Daher and Aceves, 536 T.M., Interest Expense Deductions, and Maruca and Warner, 886 T.M., Transfer Pricing: The code, the Regulations, and Selected Case Law, and in Tax Practice Series, see ¶3600, Section 482 - Allocations of Income and Deductions Between Related Taxpayers.


  1 The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP.

  2 Within just days of each other, both the European Commission and the Organisation for Economic Co-operation and Development (OECD) last year issued papers dealing with so-called "double non-taxation" situations.  On Feb. 29, 2012, the European Commission launched its public consultation on factual examples of double non-taxation. In early March 2012, the OECD published a report focusing on hybrid mismatch arrangements that can lead to unintended double non-taxation. And as this commentary goes to press, the OECD has just released its report, "Addressing Base Erosion and Profit Shifting."

  3 NA General Partnership et al. v. Comr., T.C. Memo 2012-172.

  4 PepsiCo Puerto Rico, Inc. et al. v. Comr., T.C. Memo 2012-269.

  5 827 F.2d 1409 (9th Cir. 1987).

  6 Laidlaw Transportation v. Comr., T.C. Memo 1998-232.

  7 Mixon Jr. v. U.S., 464 F.2d 394 (1972).

 

  8 See, e.g., Tobin, "Bad Debts?" 41 Tax Mgmt. Int'l J. 299 (6/8/12).