Tax Considerations for Leveraging Foreign Investment in the United States
September 28, 2016
The US market holds immense opportunities for many foreign companies, but along with it comes a number of pitfalls that they must navigate in order to ensure success. Not the least of these hurdles are US tax considerations that must be addressed before expanding into the US. The primary focus of this article is the ability of foreign companies to leverage their business operations in the US and the resulting US tax benefits.
Overview. When a foreign company invests in the US, it is generally advisable that the US operations are conducted in a separate US subsidiary corporation. While the profits of the US corporation will be subject to US tax, such tax liability can be reduced by having the US corporation issue some debt to its foreign shareholder when the US corporation is capitalized. Leverage in the US corporation is beneficial because the repayment of principal on debt owed by the US corporation to the foreign shareholder should not subject to US withholding tax and interest payments on the related party debt are generally deductible for US tax purposes (but, only if the debt is properly structured and documented).
There are a number of issues to consider when the US corporation issues related party debt to a foreign shareholder. The parties need to be cautious with respect to: (1) the amount of debt; (2) the debt instrument must reflect arm’s length terms (including an arm’s length interest rate); (3) the US corporation needs to have an acceptable debt-to-equity ratio; and (4) the parties should act in accordance with the terms of the debt instrument. Moreover, foreign companies need to be aware of certain documentation rules included in proposed regulations under Section 385.
Setting up a US Corporation. If a foreign company conducts business in the US as a standalone foreign entity, then the foreign company will likely have a US trade or business or a permanent establishment in the US. The consequences of this arrangement is that foreign corporations will be subject to tax return obligations in the US and income attributable to the US operations will be subject to US tax (including a branch profits tax). The foreign company can generally avoid a US trade or business and a permanent establishment in the US by forming a US subsidiary corporation to conduct the US operations. In such case, the US corporation will file its own US federal tax return and income earned by the US corporation will be subject to US tax (including a US withholding tax on dividends). Although the US corporation is subject to US tax, a foreign shareholder can generally avoid US capital gains tax on the sale of the stock of the US corporation. Additionally, the US tax liability of the US corporation can be reduced by inserting leverage into the US corporation.
Tax Benefits from Leverage. When setting up and funding operations in the US corporation, it is generally advantageous for the US corporation to issue some debt to its foreign shareholder. Leverage in the US corporation is beneficial because the repayment of principal on debt owed by the US corporation to the foreign shareholder is not subject to US withholding tax (that may otherwise be imposed on a distribution from the US corporation to a foreign shareholder). Moreover, interest payments on the related party debt are generally deductible for US tax purposes (subject to certain limitations). Depending upon the tax characterization and the tax residency of the foreign shareholder, US withholding tax on interest payments may be eliminated or reduced under the so-called portfolio interest exemption or under an applicable tax treaty. While the interest income may be taxable in the country of the foreign shareholder, income tax rates in foreign countries are generally lower than income tax rates in the US. Accordingly, the insertion of leverage into the US corporation can result in an overall reduction of tax.
There are a number of issues to consider when the US corporation issues related party debt to a foreign shareholder.
Bona Fide Debt for US Tax Purposes. To achieve the benefits of a reduction in US withholding tax and interest deductions, the debt must be respected as bona fide debt for US federal income tax purposes. The determination of whether a debt instrument will be respected as bona debt is based upon a number of factors.
Section 385 of the Internal Revenue Code provides factors which are to be taken into account in determining whether a bona fide debtor-creditor relationship exists in the context of a shareholder loan to a corporation. The factors include, but are not limited to:
(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 debt-to-equity ratio 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.
Case law has also identified a number of factors to be used when analyzing a debt instrument and a debtor-creditor relationship. The most common factors include, but are not limited to:
(1) Intent of the Parties. Courts generally look at the terms of the debt instrument and the actions of the parties to determine whether the parties intended to create a bona fide debtor-creditor relationship. To this end, the parties should: (1) execute a legal document that is labeled as debt; (2) reflect the instrument as debt in their records and financial statements; and (3) act in accordance with the terms of instrument
(2) Lack of Voting Rights and Participation in Management. The lack of a right to participate in management, directly or through voting rights in connection with the instrument weighs in favor of debt treatment.
(3) Right to Enforce Payment. The right to enforce payment of interest and principal supports debt treatment. To this end, courts have held that the presence of collateral, an acceleration clause and/or restrictive financial covenants on the borrower supports debt treatment.
(4) Source of Interest Payments. The entitlement to unconditional interest payments irrespective of corporate profits supports debt treatment.
(5) Risk of Venture. A debtor with predictable and consistent cash flows weighs in favor of debt treatment.
(6) Subordination to Other Indebtedness. The existence of a priority over other indebtedness, whether already incurred or to be incurred, supports debt treatment.
(7) Conversion Rights. The existence of a fixed conversion right at the lender’s option that provides that lender with economic upside of the debtor’s business is generally a negative factor for debt treatment.
(8) Ability to Obtain Funds from a Third-Party Lender. The ability of the debtor to obtain funds under similar terms from a third party weighs strongly in favor of debt treatment.
(9) Thin Capitalization. The debtor should not be thinly capitalized. Generally, a 2-to-1 debt-to-equity ratio may be considered reasonable while a debt-to-equity ratio in excess of 5-to-1 may be problematic. There is no specific debt-to-equity ratio requirement to determine whether a debtor is adequately capitalized. Courts will examine industry specific standards to determine whether a debtor has an acceptable debt-to equity ratio.
In the context of related party debt, courts will scrutinize: (1) whether the debt instrument has arm’s length terms (such as an arm’s length interest rate, a right to acceleration and payment upon certain events of default, financial covenants, and an acceptable maturity date) and; (2) the ability of the debtor to pay interest and principal in accordance with the terms of the note.
Finally and most importantly, even if the debt instrument has arm’s length terms, it is critical that the debtor make timely interest payments and that the creditor acts as bona fide creditor with respect to any late interest payments. The failure to act as a bona fide debtor and creditor with respect to interest payments is fatal to having a debt instrument being classified as bona fide debt for US tax purposes.
Proposed Regulations under Section 385. Foreign companies also must be aware of certain documentation rules included in proposed regulations under Section 385. The proposed regulations were issued on April 4, 2016 and would generally apply retroactively to related party debt instruments issued on or after that date (but, there is a grace period that allows debtor corporations to repay the related party debt within 90 days after the regulations are finalized). The documentation rules require the foreign company and the US debtor corporation to have evidence that the related party debt contains characteristics of a third-party debt instrument including arm’s length terms and that the US debtor corporation has the financial ability to pay interest and principal in accordance with the terms of the note.
The documentation requirements under the proposed regulations only apply to certain affiliated groups with: (1) one member whose stock is publicly traded; (2) more than $100 million of total assets as reported on a non-tax audited financial statement; or (3) more than $50 million of total annual revenue as reported on a non-tax audited financial statement.
Notwithstanding such thresholds, it is recommended that public and private companies of all sizes follow the documentation rules regardless of whether the proposed regulations are finalized. For the most part, the documentation rules under the proposed regulations adopt existing authority that has been established under case law.
The proposed regulations and case law require that each related party debt instrument have arm’s length terms or the related party debt will not be respected as debt for US federal income tax purposes. Documentation of evidence that supports: (1) an arm’s length interest rate; (2) an acceptable debt-to-equity ratio; and (3) the financial ability of the US debtor corporation to service the debt instrument will go a long way in defending the classification of the debt instrument in the event of an of an audit by the IRS.
If a taxpayer is subject to the proposed regulations, it must maintain such documentation for all taxable years in which the debt is outstanding and until the statute of limitations expires for any return with respect to which classification of the debt instrument is relevant. We recommend that all taxpayers follow this rule regardless of whether the taxpayer is subject to the proposed regulations and regardless of whether the regulations are finalized.
Documentation and Support for Arm’s Length Interest Rate, Debt-to-Equity Ratio and Financial Ability of the US Debtor. It is further recommended that the foreign investor and the US debtor corporation engage a US accounting firm (or other qualified financial advisor) to perform a debt capacity analysis and issue a report to support: (1) an arm's length interest rate; (2) an acceptable debt-to-equity ratio; and (3) the financial ability of the US corporation to service the debt. Such a report should evaluate the underlying economics and business of the US debtor corporation and take into account the credit rating, historical financial information and projected cash flows of the US debtor corporation. A debt capacity report from an independent third party with proper qualifications will be powerful evidence to support the legitimacy of the debt.
If the amount of the debt is not significant enough to justify the payment of fees to an independent third party for a debt capacity report, the taxpayer should (at a minimum) document internal cash flow projections of the US debtor corporation to show that it has the financial ability to service the debt in accordance with the terms of the debt instrument. The cash flow projections should be as of the date of issuance of the debt and should also consider the possibility of deviations from expected cash flow.
The taxpayer should also document its justification for its arm’s length interest rate such as using an interest rate based upon the credit rating of the company and using a rate that is consistent with any third party debt of the US debtor corporation. The debt-to-equity ratio should be also based upon an acceptable ratio for the particular industry of the US debtor corporation.
Limitation on Interest Deductions under Section 163(j). In addition to the debt classification rules, foreign companies need to be aware of potential limitations on interest deductions under Section 163(j). Section 163(j) basically acts as a thin capitalization rule. The rule places a limitation on deductions for interest paid to a related party that is not subject to (or that is partially exempt from) US tax. The limitation can only apply if the US debtor corporation has a debt-to-equity ratio of 1.5 or greater. The limitation applies to “excess interest expense” incurred by the US debtor corporation. Excess interest expense is generally defined as interest expense exceeding 50% of the US debtor corporation’s Adjusted Taxable Income (ATI) (basically, operating profits of the US debtor corporation with some exceptions). Excess interest expense that is disallowed can be carried forward for use in subsequent tax years, without limitation. To the extent the interest expense is below the limitation, this “excess limitation” can be carried forward three years and included with that year’s ATI to increase the limitation.
Conclusion. The foregoing discussion provides a high-level overview of US tax related issues that a foreign company should consider when expanding its business operations into the US. Using a leveraged US corporation to conduct the US operations can result in US tax savings. However, the parties need to be cautious with respect to the amount of debt, the debt instrument must reflect arm’s length terms (including an arm’s length interest rate), and the parties should act in accordance with the terms of the debt instrument. The parties should also document its justification for: (1) an arm's length interest rate; (2) an acceptable debt-to-equity ratio; and (3) the financial ability of the US corporation to service the debt. Finally, foreign companies need to be aware that there are many other commercial, legal and tax considerations that must be taken into account before moving forward with an investment in the US.
Information in this article is not intended as legal or tax advice to any person. All readers must rely on their own legal and tax advisors. Tax law is also subject to change and the IRS may not agree with the conclusions reached in this article.