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


Author:  Galia Antebi.; Nina Krauthamer.


Source: Volume 27, Number 06, July/August 2014 , pp.5-9(5)




Journal of Taxation and Regulation of Financial Institutions

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Abstract: 

Internally financing or capitalizing a U.S. subsidiary with intercompany indebtedness raises tax issues that are currently on the IRS’s radar screen. Will a debt instrument be recognized as true debt and not as equity? The incentive to finance a U.S. subsidiary with debt is clear. This country has one of the world’s highest corporate tax rates—and states impose separate taxes on business operations taking place in their state. By inserting debt into the equation, a U.S. subsidiary has the ability—subject to the limitations applicable under the general tax rules—to deduct some or all of the interest payments and consequently reduce the effective tax rate applicable to the U.S. operations. Such interest payments will be subject to U.S. tax, at a reduced rate (or zero) if the recipient is a resident of a treaty country. The IRS examines debtor-creditor relationships that cannot be negotiated on arm’s length terms because the parties re related. In the IRS’s view, amounts may be disguised as debt that really are equity if the true economics of the parties demonstrate an equity investment. The IRS’s attempts to issue regulations in this area have been a failure, and taxpayers and the courts instead look to standards based on extensive case law. These cases have developed objective and subjective approaches, each relying on a series of factors. This article elaborates on the factors to be considered and surveys recent cases examined by the courts.

Keywords: debt versus equity ratio; related party; intercompany debt; true debt

Affiliations:  1: Ruchelman P.L.L.C.; 2: Ruchelman P.L.L.C..

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