Why is the IRS bringing debt-equity cases? Former IRS Chief Counsel Donald Korb of Sullivan & Cromwell LLP speculated that it is because then-IRS Commissioner Mark Everson needed a longer list of international issues when he appeared before Congress to be grilled about international enforcement.
Whatever the reason, the IRS is bringing more cross-border debt-equity cases in contexts in which section 163(j) is also being argued. The IRS Large Business and International Division is believed to have 300 active debt-equity cases in its inventory. Tyco International Ltd. has a huge case docketed in the U.S. Tax Court.
Korb and his partner James Gadwood spoke at the International Tax Institute in New York on January 21. They encouraged practitioners faced with debt-equity questions on audit to try to dispose of them as early as possible in the process and to marshal their facts to tell a coherent, flattering story.
"Develop the facts and the law will follow," said Korb. Indeed, all of the cases Korb and Gadwood discussed were Tax Court memorandum decisions.
In Nestle Holdings v. Commissioner, T.C. Memo. 1995-441, the court took a holistic approach to the debt-equity question. In PepsiCo Puerto Rico Inc. v. Commissioner, T.C. Memo. 2012-269, and ScottishPower (NA General Partnership v. Commissioner, T.C. Memo. 2012-172), the courts just went through the factors listed in Estate of Mixon, 464 F.2d 394 (5th Cir. 1972).
Facts can be troublesome things. In the usual cross-border situation, the multinational has made an intragroup loan for purposes of stripping income out of the borrower's jurisdiction. Interest is being paid currently and in cash. The loan is documented.
Things can go downhill from there. Often principal is not being paid. Maturity dates may be ignored. Debts are routinely rolled over. The debt plan may have been marketed by an accounting firm. The interest charge may diverge from the borrower's theoretical or actual outside rate. The borrower may be paying dividends instead of principal. The borrower may not have the ability to repay the debt. Several of these bad facts were present in Laidlaw Transportation v. Commissioner, T.C. Memo. 1998-232, which the taxpayer lost on a Mixon analysis.
The debt may be an arbitrage play that is treated as equity in the lender's country of residence. Laidlaw featured a hybrid. But Pepsi successfully argued that its 40-50 year advances were equity. The IRS was in the peculiar posture of arguing for debt treatment and argued that the shareholder/lender identity did not matter. Korb argued that the IRS is hurting itself by making inconsistent arguments and muddying the waters for future precedent.
Korb encouraged his audience to address these negatives in the context of common business practice. Debt often is not retired. Borrowers commonly pay dividends while leaving debt in place instead of retiring it. The borrower must demonstrate the ability to pay the principal. And failure to retire a debt when the borrower has come into a large chunk of cash from a sale or other transaction requires explanation.
It's obviously good to have a credible business purpose for the intragroup debt. The ScottishPower court justified interest deductions on inbound advances with a factual finding that the funds were used for a U.S. acquisition. The advances were represented by redeemable medium-term unsecured notes that paid interest in arrears. Interest was paid. The advances were partially repaid and partially capitalized into equity.
In a large case, the IRS brings a small army of specialists, including finance specialists, economists, and international specialists. Korb noted that the taxpayer has a problem if the IRS National Office gets involved. He encouraged practitioners to get the taxpayer's finance department involved.
If the borrower's debt-equity ratio is ugly, Korb suggested that the taxpayer argue for a favorable valuation of the equity side that includes goodwill and future earnings. In Laidlaw, the taxpayer unsuccessfully argued that fair market value of its equity side of the balance sheet should be used instead of book value.
But the IRS currency initiative may mean that the taxpayer has to answer the IRS's 30-day notice in its own protest. Moreover, the IRS's quality examination process may mean that summonses are issued sooner when information document requests are not answered promptly, in spite of requests for enormous amounts of information.
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