tax homework

Travis A. Wise
 
Question 1 – Bank Finance
Your client, X Inc, is a US corporation that is looking to refinance its operations.  It is approached by a Bank that has an arrangement that will provide a much lower rate of finance to X Inc that it is currently able to obtain. 
What issues should you advise your client to consider when reviewing this finance arrangement?

1.    Back-to-Back Loans
The validity of the Bank’s back-to-back loan arrangements should not be of direct concern to X because Bank is an unrelated party.  However, X’s legal counsel will likely want assurances from Bank that the back-to-back loan arrangement is bona fide, to avoid future complications.  Because the back-to-back loan provides for a small margin of interest to be earned by Bank and UK Branch, the loan would likely be viewed as complying with the arm’s length and transfer pricing rules of each jurisdiction.
2.    Withholding Tax on Interest
The UK branch of the Bank should not be considered a resident of the U.K. for purposes of applying the U.K. treaty to Bank.  This is because under the residency clause of the UK treaty, the “resident” must be a corporate form. 
Assuming that Bank is not a resident of the U.S. or of a country with a treaty with the U.S., interest paid by X to the UK branch of Bank will be subject to standard U.S. withholding tax on interest payments at 30%. 
If Bank is a resident of Australia, the U.S. has a tax treaty with Australia that provides for a reduced rate of 10% withholding tax on interest payments.
Most treaties follow the model treaty provisions which deny treaty benefits to residents of the treaty country if one of the residents acts as a conduit for transmitting income from US sources to persons who are not residents of the treaty country.  This provision should not apply, because even though Bank is a resident of a treaty country, Lux is also a resident of a treaty country, and therefore this transaction is not undertaken for purposes of treaty shopping.
3.    Excess Interest Expense
Section 163(j) applies to limit interest deductions to a corporation that has "excess interest expense" for a taxable year. Excess interest expense is any excess of interest expense over 50 percent of the adjusted taxable income plus any excess limitation carryforward.  The amount of excess interest expense for a taxable year is not deductible to the corporation.
If a corporation has an excess limitation in a taxable year, that limitation carries forward to the first, second, and third taxable years that follow.
 

Question 2 – Real Estate
Your client is a non-US person who is proposing to invest in a United States (“US”) Limited Liability Company (“LLC”), which will acquire and develop land in the US with the intention of selling the properties on completion.
The proposal is for your client to contribute 80% of the capital in the LLC with the remaining 20% being contributed by another person, who will be the developer.  The capital contribution by your client will be sourced via a mixture of its own funds and debt financing obtained by it.  In turn, the LLC will use these proceeds, together with funds contributed by the other developer and non recourse debt, to acquire and develop the land into a five star condominium complex with the intention of selling the properties on completion.
It is expected that the first of the condominium’s will be sold in three (3) to four (4) years time; with the expectation that all of the condominiums will be sold within eight (8) years.
1.    Source of Income
Gains, profits, and income from the disposition of real estate is sourced to where the property is located.  Since the property would be located in the U.S., any gains, profits, or income from the disposition of real estate would constitute U.S.-Source income.
2.    Tax on Disposition of Real Property Interest
Under Section 897, “Disposition of Investment In United States Real Property”, a foreign taxpayer must pay U.S. income tax at the regular rates on the net gains derived from the sale or other disposition of U.S. real estate and U.S. real property interests.  Under this provision, gains and losses from real property owned by nonresident individuals or foreign corporations are considered effectively connected with a U.S. trade or business.
Section 897 applies to U.S. real property interests (“USRPI”) as defined in Section 897(c).  A USRPI is any interest in real property located in the U.S.  A USRPI also includes the shares of a domestic corporation that is considered a U.S. real property holding corporation (“USRPHC”). A USRPHC is a U.S. corporation where the fair market value of its U.S. real property interests is 50% or more of the combined assets of the corporation. 
3.    Treatment as USRPHC
Assuming that LLC’s assets consist of 50% or more of U.S. real property interests, LLC may be a USRPHC. 
If LLC elects to be treated as a corporation for U.S. tax purposes, then a foreign investor will be treated as having a USRPI in the shares of the LLC. 
If LLC is treated as a partnership for U.S. tax purposes, then the foreign investor will be treated as having a USRPI in the holdings of the partnership.  The "look-through" rule contained in Section 897(g) provides that the amount of money and the fair market value of any property received by a non-resident alien individual or foreign corporation in exchange for all or part of its interest in a partnership is, to the extent attributable to U.S. real property interests, treated as an amount received from the sale or exchange in the U.S. of such property.  Thus, that portion of the gain or loss on the disposition of the interest in the partnership, trust, or estate is subject to Section 897(a).
4.    Tax Withholding Requirements on USRPHC
A tax return must be filed for the taxable year of the distribution or transfer of a USRPHC. In addition, Section 1445 requires withholding taxes when a USRPI is transferred.  Generally, Section 1445 requires 10% of the total gross price (not just net gain) to be withheld from the proceeds of a transfer of a USRPI.
5.    Use of a Foreign Corporation
I would advise the foreign investor to hold his interest in the LLC through a foreign corporation.  Using a foreign corporation as a shareholder will not offer exemption from U.S. tax, but will provide deferral of U.S. taxation on the appreciation of the U.S. real property, because sales of the shares of the foreign corporation will not be subject to U.S. tax. 
A USRPI includes a foreign corporation that makes an election under Section 897(i) to be treated as a domestic corporation that is a USRPHC. This election is allowed if the foreign corporation holds a USRPI.  Making the election will allow the foreign company to be considered a domestic company for purposes of claiming treaty benefits.  Otherwise, the USRPHC will be subject to U.S. tax but unable to take advantage of treaty benefits, such as exemption from double taxation. 
6.    Planning Opportunities
The foreign person may be able to avoid tax under Section 897 by the use of a hybrid debt instrument.  If the foreign person makes an investment in the LLC which is classified as equity in the jurisdiction of the non-U.S. person but as debt for U.S. tax purposes, the foreign person may be able to avoid tax under Section 897. 
Section 897 does not apply to creditors’ interests in a U.S. real property holding company.  However, the regulations under Section 897 contain their own rules for determining whether purported debt is an interest subject to Section 897.  If a loan gives the holder of the indebtedness any direct or indirect right to share in the appreciation in the value of an interest in real property of the debtor or of a related person, or any right to share in the gross or net proceeds or profits generated by such property, the loan is an interest in real property, other than solely as a creditor. 
Because the primary interest in investing in real property is to profit from the appreciation in value of the real property, using debt as a alternative may not be attractive.
 

Question 3 – Guarantee Fee
X Co, a Netherlands company, which is a wholly owned subsidiary of a Netherlands publicly listed company, is proposing to commence business in the US.  We understand that the structure to be used to run and maintain the US business is still being determined.  However, irrespective of the final business form, the US business operations will be owned by a US corporation, Y Inc, which will be a wholly owned subsidiary of X Co.
We understand that X Co has determined that Y Inc will require $50 million in finance in order to commence business in the US.  This finance will be provided via a mixture of debt and equity, the exact rations of this are yet to be determined.  However, during initial discussions with your client they have indicated that they are thinking of injecting $1 million in equity with the remainder of the finance being provided in the form of debt.
With respect to any debt finance we understand that the debt will be provided by a US Bank or a consortium of US Banks (Hereinafter referred to as US Bank).  The term of any debt will be between twelve (12) to thirteen (13) years with a fixed interest rate of six percent (6%); however it is understood that preliminary estimates prepared by X Co indicate that the debt should be paid off in six (6) to seven (7) years out of Y Inc’s operating profits.  Y Inc will provide some security over the assets it will own, but the greater security is being provided via X Co who will guarantee the debt from US Bank to Y Inc.
(a)    For US federal income tax purposes what are the limits on the deductibility of interest by Y Inc on finance provided by a US Bank?
(b)    Would your answer to question (a) change if the finance was provided by a non-US Bank?
Section 163(j) provides for the disqualification of deduction for certain interest payments.  Disqualified interest includes interest paid or accrued to a related person, either directly or indirectly.  "Disqualified interest" also refers to any interest paid or accrued by a corporation on debt owed to a person who is not a related person if (1) there is a "disqualified guarantee" of such debt and (2) no gross basis tax is imposed by the U.S. on such interest.
No gross basis tax is imposed by the U.S. on interest paid to a non-U.S. bank.  Gross basis tax would be imposed by the U.S. on interest paid to a U.S. bank.  However, interest paid to a U.S. bank and reported as gross income may be treated as disqualified interest if the loan is guaranteed. 
Section 163(j) generally does not apply when a corporation pays interest to an independent party. However,  interest on a debt owed to an independent party may be treated as disqualified interest if a related person of the debtor guarantees the debt and that related person is a a foreign person.
In order to be subject to Section 163(j) the corporation’s debt to equity ratio must exceed 1.5 to 1 at the close of the year, and there must also be “excess interest expense”.  If both of these conditions exist, no deduction is allowed for the disqualified interest.
Section 163(j) applies to limit interest deductions to a corporation that has "excess interest expense" for a taxable year. Excess interest expense is any excess of interest expense over 50 percent of the adjusted taxable income plus any excess limitation carryforward.  The amount of excess interest expense for a taxable year is not deductible to the corporation.
If a corporation has an excess limitation in a taxable year, that limitation carries forward to the first, second, and third taxable years that follow.
(d)    Is there any advice you could give your client that may improve the tax aspects of this proposed investment?
I would  recommend to the client that it may be preferable to have X Co. borrow the $49 million of funds from a Dutch bank, rather than the U.S. company borrowing the funds.  X Co. can then contribute the loaned funds to Y Co. as equity, thus avoiding creating a debt to equity ratio issue, and creating nondeductible interest. 
Any amount that X Co. lends to Y. Co. as debt should be carefully examined to make sure it is not equity.  The IRS may recharacterize debt that is not considered bona fide debt as equity. If intercompany debt is treated as equity, interest payments will be treated as dividend distributions for U.S. tax purposes, which is usually something a company wants to avoid.

The following common-law factors are generally used to determine if debt is bona-fide:

1. Extent to which lender controls borrower.
2. Whether or not the debt is secured.
3. Whether the borrower is in a financial position to repay the loan.
4. Whether the borrower has adequate earnings and profits to constitute a dividend (as opposed to a return of capital).
5. Whether the debt is evidenced by a written note.
6. Whether there is a repayment schedule or an attempt to repay.
7. Evidence of a set maturity date (term /duration of the loan).
8. Whether the lender charges interest.
9. Whether the lender has taken steps to obtain repayment.
10. The magnitude of the advances, such that repayment is contingent on the future success of the borrower.
11. If there is a maximum amount of credit that can be extended.
12. Dividend history of the corporation.

Other factors that should be considered are thin capitalization (for which there is little IRS guidance and no safe harbor), withholding tax rules, and the earnings stripping rules under 163(j) (for which there is a safe harbor).

From a practical standpoint, the company should also make sure their interest rate is arm's-length, and they may want to take advantage of the safe haven rate in Reg. 1.482-2(a)(2)(iii)(B) of a range of 100-130% of the AFR.
 
 

Question 4 – Finance
Your client is M Co, a non-US corporation, which has a wholly owned US subsidiary (US Inc).  M Co is proposing to finance US Inc and they have come to you to review the terms of the financial instrument.  They have told you that the instrument is regarded as equity for purposes of the jurisdiction in which M Co is resident.  The terms of the financial instrument are as follows:
(a)    Not payable on demand;
(b)    Five hundred (500) year term;
(c)    Interest at “LIBOR plus” rate (exact rate to be determined);
(d)    Neither “interest” nor “principal” are repayable if US Inc has no earnings and profits (“E&P”) in any given year;
(e)    Deferred interest compounded to principal;
(f)     Claims arising as a result of the advance would be junior to US Inc secured and unsecured liabilities, but senior to all shares (ordinary or any other class) issued or to be issued by US Inc;
(g)    The instrument is secured by US Inc assets;
(h)    M Co is entitled to repayment of both unpaid principal and any accumulated interest, limited to US Inc’s E&P, upon occurrence of the following:
(i) Call of securities by US Inc;
(ii) Put of securities by M Co; and
(iii) Liquidation or dissolution of US Inc.
(i)      M Co can freely transfer the instrument after a specified number of years.
Your client has asked that you advise them of the US federal income tax issues that surround the issue of this instrument.
Section 385(b) authorizes Treasury to proscribe regulations to take into account whether a certain transaction is debt or equity for U.S. tax purposes.  The Code provides that the regulations may include, among other factors:

(1) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest,

(2) whether there is subordination to or preference over any indebtedness of the corporation,

(3) the ratio of debt to equity of the corporation,

(4) whether there is convertibility into the stock of the corporation, and

(5) the relationship between holdings of stock in the corporation and holdings of the interest in question.

Treasury has not yet issued regulations under Section 385.  Therefore, the courts have developed common law factors, in addition to the above factors, to determine whether an instrument is debt or equity for U.S. tax purposes.  The following common law factors are considered:

1. Extent to which lender controls borrower.
2. Whether or not the debt is secured.
3. Whether the borrower is in a financial position to repay the loan.
4. Whether the borrower has adequate earnings and profits to constitute a dividend (as opposed to a return of capital).
5. Whether the debt is evidenced by a written note.
6. Whether there is a repayment schedule or an attempt to repay.
7. Evidence of a set maturity date (term /duration of the loan).
8. Whether the lender charges interest.
9. Whether the lender has taken steps to obtain repayment.
10. The magnitude of the advances, such that repayment is contingent on the future success of the borrower.
11. If there is a maximum amount of credit that can be extended.
12. Dividend history of the corporation.

In our case, the lender controls the borrower through a parent-subsidiary relationship.  The debt is secured by U.S. assets, and the lender is entitled to repayment of principal and interest upon bankruptcy of the borrower.  However, this security only applies if U.S. Inc. has positive E&P.  If U.S. Inc. does not have positive E&P, neither interest nor principal are repayable.  Additionally, the note is not payable on demand, and interest is compounded to principal without requirements of payment.  Claims arising under the debt are junior to all other liabilities, but senior to equity.  The term of the loan is indefinite (500 years), and the lender can freely transfer the instrument.
All of these factors point to the debt being treated as equity.  Parties operating at arm’s length would not agree to the terms of this “loan”, and the instrument does not have any indicia of being bona fide debt.  Specifically:
1. The lender has 100% control of the borrower.
2. The debt is effectively not secured, because there is no recourse if U.S. Inc. does not have E&P.
3. The borrower may be in a financial position to repay the loan, but if it does not have E&P, it is not obligated to do so.
4. There is no indication the borrower will attempt repayments, since repayments are not required until the loan matures.
5. The set maturity date is 500 years into the future.
Therefore, the IRS would most likely find this instrument to be equity, and any interest payments would be treated as dividends for U.S. tax purposes. 

Question 5 – Reorganizations
Your client, X Co, is a non-US publicly listed company resident in a country that does not have an income tax treaty with the US.  It currently has a number of active subsidiaries in the US (“US subs”), which have a current fair market value of $13M.  These subsidiaries are all owned directly by X Co and as such they currently do not form a US consolidated group.  In discussions with your client you notice that some of the US subs are profitable but some are not and you are told that this situation is expected to continue for a number of years.  You explain to your client that they may want to group these companies. 
X Co will incorporate a new US corporation, Y Inc;
Y Inc will acquire the US subs from X Co in exchange for a note of $10M; and
Y Inc and the US subs will elect to form a consolidated tax group.
QUESTIONS
(a)    What advice do you give your client with respect to the proposed transaction?
(b)    Would your answer to part (a) of this question change if you knew that X Co, was a publicly listed Australian company?  If so how?
The first advice I would give to my client is to consider making a contribution of shares of the U.S. subsidiaries to Y Inc.  Such a transfer should be treated as an inbound transfer of assets.  The inbound Section 351 transfer should not result in current taxation to the shareholders of Y Inc., provided the requirements of a valid Section 351 are met, such as business purpose.
If for other business reasons or foreign tax reasons Y desires to acquire the shares in the subsidiaries from X in exchange for a note of 10M, the note would be subject to scrutiny.  Specifically, the deductibility of interest paid by Y to X would be examined.
1.    Bona Fide Debt
Any amount that X Co. lends to Y. Co. as debt should be carefully examined to make sure it is not equity.  The IRS may recharacterize debt that is not considered bona fide debt as equity. If intercompany debt is treated as equity, interest payments will be treated as dividend distributions for U.S. tax purposes, which is usually something a company wants to avoid.

The following common-law factors are generally used to determine if debt is bona-fide:

1. Extent to which lender controls borrower.
2. Whether or not the debt is secured.
3. Whether the borrower is in a financial position to repay the loan.
4. Whether the borrower has adequate earnings and profits to constitute a dividend (as opposed to a return of capital).
5. Whether the debt is evidenced by a written note.
6. Whether there is a repayment schedule or an attempt to repay.
7. Evidence of a set maturity date (term /duration of the loan).
8. Whether the lender charges interest.
9. Whether the lender has taken steps to obtain repayment.
10. The magnitude of the advances, such that repayment is contingent on the future success of the borrower.
11. If there is a maximum amount of credit that can be extended.
12. Dividend history of the corporation.

Other factors that should be considered are thin capitalization (for which there is little IRS guidance and no safe harbor), withholding tax rules, and the earnings stripping rules under 163(j) (for which there is a safe harbor).

From a practical standpoint, the company should also make sure their interest rate is arm's-length, and they may want to take advantage of the safe haven rate in Reg. 1.482-2(a)(2)(iii)(B) of a range of 100-130% of the AFR.
2.    Withholding Tax on Interest
Interest paid or accrued from Y to X would be subject to withholding tax of 30%.  If X is an Australian company, the U.S.-Australian double tax treaty would reduce this withholding tax to 10%, assuming that the residency and anti-treaty-shopping provisions do not apply.
3.    Earnings Stripping Rules
Section 163(j) provides for the disqualification of deduction for certain interest payments.  Disqualified interest includes interest paid or accrued to a related person, either directly or indirectly.
Section 163(j) applies to limit interest deductions to a corporation that has "excess interest expense" for a taxable year. Excess interest expense is any excess of interest expense over 50 percent of the adjusted taxable income plus any excess limitation carryforward.  The amount of excess interest expense for a taxable year is not deductible to the corporation.  If a corporation has an excess limitation in a taxable year, that limitation carries forward to the first, second, and third taxable years that follow.
In order to be subject to Section 163(j) the corporation’s debt to equity ratio must exceed 1.5 to 1 at the close of the year, and there must also be “excess interest expense”.  If both of these conditions exist, no deduction is allowed for the disqualified interest.
If President Bush's proposed FY2007 budget is adopted, the limitation on deductibility of interest paid to foreign related persons under Section 163(j) is tightned. The proposed budget:

1. Eliminates the 1.5 to 1 debt-to-equity ratio safe harbor against earnings stripping limitations.

2. Changes the limitation on deductible interest paid to foreign related parties from 50% to 25% of adjusted taxable income.

3. Limits the carryforward of disallowed interest to 10 years (currently unlimited).

4. Eliminates the 3 year carryforward of excess limitation.
Our client should keep these factors in mind in implementing this transaction.
4.    Matching Rules
Section 267(a)(2) provides matching rules that operate to defer the deduction of an expense if it is unpaid and is owed to a related party.  
The rules in Section 267(a)(3) treats the payment to foreign persons as being on a cash basis.  Therefore, interest payments accrued by the U.S. company to a foreign parent are not deductible until actually paid to the foreign parent.  Withholding tax is due on interest accrued to foreign parties, therefore the company may have to pay withholding tax of 30% or 10% (under the Australia-U.S. tax treaty) on accrued interest payments that the company cannot deduct.
Because intercompany transactions are generally accrued by not settled by cash payments, the accrued payments would not create additional deductions in the U.S. until paid.  Our client should keep this in mind when preparing their tax return, as well as evaluating whether debt is an tax efficient method of reorganizing their legal structure.

Popular posts from this blog

power elite vs pluralist explanation models

big 4 vs. law firm comparison from an industry perspective

california bar exam primer