Debt vs. Equity for Federal Income Tax Purposes. As a practical matter, even though these documentation regulations never came into effect, the general rules distinguishing debt from equity for federal income tax purposes developed by the IRS and the courts continue to apply. It is therefore recommended that taxpayers continue to maintain sufficient support for the treatment of their intercompany debt as debt for federal income tax purposes.
Whether a purported debt instrument is respected as debt for federal income tax purposes is determined based on all the facts and circumstances and on the substance, rather than the form, of the relationship between the parties. The difference between a stockholder and a creditor is generally that a creditor expects to receive a return on its investment without regard to the performance of the debtor’s business. The courts have therefore held that the most important factor in characterizing an instrument as debt is an unconditional right to a return of principal on demand or at a reasonable pre-determined maturity date.
Other factors that courts and the IRS have considered in making this determination include:
(i) the ability and intention of the debtor to repay and service the debt;
(ii) whether the issuer of the debt has sufficient equity capital for its line of business or is thinly capitalized without an adequate equity cushion that would reduce the risk of payment default (whether a debtor is thinly capitalizes depends on the industry, in the financial sector, for example, high debt-to-equity ratios are more common);
(iii) whether holders of the instrument possess the right to enforce the payment of principal and interest;
(iv) whether the rights of the holders of the instrument are subordinate to the rights of general creditors;
(v) whether the instrument gives the holder the right to participate in the management of the issuer;
(vi) whether there is identity between the holders of the instrument and stockholders of the issuer;
(vii) the label placed on the instruments by the parties; and
(viii) whether the instrument is intended to be treated as debt or equity for nontax purposes.
No particular factor is conclusive in making this determination, and the weight given to any factor depends upon all the facts and circumstances.
No Change to Debt Recharacterization Regulations. The proposed regulations do not affect Treasury Regulations § 1.385-3, which treat as equity certain debt that is distributed by a corporation to a controlling shareholder or issued in other related-party transactions with similar economic results. These rules therefore continue to be in effect.