Financing a U.S. subsidiary
When a Canadian company creates a U.S.-based subsidiary, one of the first issues to be addressed is how to fund those operations. Generally, funds may be advanced in the form of equity, debt or a combination of both.
Where funds are contributed by way of equity, they may be returned to the Canadian parent by way of a distribution from the U.S. subsidiary. For U.S. tax purposes, that distribution is treated as a dividend to the extent of the U.S. subsidiary's current or accumulated earnings and profits. A dividend is subject to U.S. withholding tax of five per cent in the case of a Canadian corporation owning at least 10 per cent of the voting stock of the U.S. subsidiary under the Canada-U.S. Tax Convention. The U.S. subsidiary does not receive an income tax deduction for this dividend payment.
Alternatively, where funds are loaned to the U.S. subsidiary, the subsidiary is entitled to an income tax deduction for interest paid on the loan, subject to various limitations discussed below. The interest payment is not subject to U.S. withholding tax under the Canada-U.S. Tax Convention. Repayments of loan principal are not deductible by the borrower. Because of the potential tax rate differential on funds flowing through to the ultimate Canadian shareholders of the Canadian parent by way of interest rather than dividends, debt financing of Canadian-owned U.S. subsidiaries can be an attractive option.
What constitutes a debt?
For U.S. federal tax purposes, indebtedness exists only if the parties to the obligation intended to create a debt. The debt must be legally enforceable, provable and unconditional. The Internal Revenue Code (IRC) does not define "debt," leaving taxpayers to look to judicial history on the subject. In classifying a security as debt or equity, the courts have looked to many factors, including:
- the intent of the parties;
- the existence of a written document evidencing the indebtedness;
- the presence or absence of a fixed maturity date;
- the presence or absence of a stated interest rate;
- the right to enforce payment of principal and interest;
- adequacy of the borrower's capitalization, typically interpreted as not more than a 3:1 debt to equity ratio; and
- the expected ability of the borrower to satisfy the loan in accordance with terms at the inception of the loan.
No single factor is dispositive. The challenge in making a debt-equity determination in the case of non-arm's length parties is even greater as there is often an existing equity relationship. This is an area of Internal Revenue Service scrutiny, so particular care must be taken to ensure the economic realities of the transaction match the stated form. The determination of debt-equity status is made at the time the security is issued. That initial characterization is binding on both the issuer and the holder – but unfortunately not on the IRS.
If a taxpayer fails to satisfy these requirements for debt characterization upon examination by the IRS, payments from the U.S. subsidiary to its Canadian parent that were thought to be deductible interest payments and subject to 0 per cent withholding could be recharacterized as non-deductible dividend payments, subject to five per cent withholding tax. Additionally, the payment that is recharacterized as a non-deductible dividend for U.S. tax purposes may still be characterized as interest and subject to tax for Canadian tax purposes. Care is required to ensure that the U.S. debt characterization requirements are satisfied whenever there is U.S. indebtedness.
General deductibility requirements
Assuming the debt classification requirements discussed above are satisfied, further analysis is required to determine the deductibility of interest for U.S. federal income tax purposes. In computing a taxpayer's income, a deduction shall be allowed for interest paid or accrued within the taxable year on indebtedness. Despite the general allowance for interest deductibility, there are numerous provisions within the IRC that could defer or deny the deduction.
Capitalization provisions
Several IRC provisions can defer deductibility of interest by requiring that it be capitalized into the tax basis of an asset. For instance, IRC §263 requires that certain expenses (including interest) be included in the cost of inventory. IRC §279 can require the capitalization of interest on indebtedness incurred by a corporation to acquire the stock or assets of another corporation.
Related party interest
A common trap for the unwary is found in IRC §267, dealing with transactions between related parties. Generally, an accrual basis taxpayer may deduct interest when accrued. However, in the case of interest to a foreign related person, the interest must actually be paid for it to be deductible by the taxpayer. The term "related person" is defined broadly and includes a person with a greater than 50 per cent ownership interest in the corporation. Furthermore, constructive ownership rules apply. For example, assume a Canadian parent loans funds to its wholly owned U.S. subsidiary and interest is accrued but unpaid by the end of the taxable year. IRC §267 would deny the U.S. subsidiary a deduction for the accrued interest. However, under Canadian tax principles the accrued interest may be taxable to the Canadian parent, creating a current income inclusion in Canada without a corresponding current deduction in the U.S. The U.S. subsidiary should be allowed a deduction in future periods if the interest is actually paid, subject to other limitations.
Although one might assume that what constitutes a payment should be straightforward, there are many situations in which it may, in fact, be unclear. A payment is considered made when the amount would be includible in the income of the beneficial owner under U.S. tax principles governing the cash basis method of accounting. Under this method, amounts not in the taxpayer's possession are constructively received only when they are credited to the taxpayer's account, set apart for him/her, or otherwise made available so that they may be drawn upon at any time. Income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.
Earnings stripping rules
The IRS uses several tactics to prevent the diminution of the U.S. tax base by a foreign corporation's excessive leveraging of its U.S. subsidiaries. The first tactic is the thin-capitalization factor of the debt-equity analysis discussed above. Where the amount of a shareholder debt far exceeds that shareholder's capital in the subsidiary, the IRS can question whether the shareholder/lender would treat the debtor in the same manner as an unrelated lender would. It is widely assumed that a debt to equity ratio that does not exceed 3:1 generally will be respected by the IRS. In calculating this ratio, the fair market value of assets and liabilities rather than their historical or book values should be used.
IRC §163(j) targets earnings stripping by disallowing current deductions for interest paid to foreign related parties under certain circumstances. The provision applies only to taxpayers with a debt to equity ratio in excess of 1.5:1. The calculation is complex, but as a general rule, interest paid to a related party (or to a third party on debt guaranteed by a related party) may be disallowed to the extent it exceeds 50 per cent of the payer's earnings before interest, depreciation, amortization and taxes. Disqualified interest amounts may be carried forward to future years but may not be carried back. When considering the amount of foreign related party debt to put into the U.S., careful modeling is required to ensure full U.S. interest deductibility.
Transfer pricing
The U.S. has extensive transfer pricing rules that seek to ensure related party transactions are conducted on an arm's-length basis (i.e., in the same manner as unrelated parties would act). Under these rules, the IRS has the authority to make adjustments to a taxpayer's income to prevent the evasion of taxation or to reflect the taxpayer's income more clearly. Related party interest is subject to these rules that might potentially deny the interest deduction, in whole or in part, if the arm's-length standards are not satisfied. Furthermore, the U.S. transfer pricing rules require that contemporaneous documentation be prepared to substantiate that the related party interest is at arm's length.
Conclusion
Although loans from a Canadian parent to its U.S. subsidiary might appear straightforward at first glance, there are numerous traps that must be avoided to ensure debt treatment and full deductibility of interest payments for U.S. income tax purposes. Careful tax planning is required. Contact your Collins Barrow advisor for help.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
