The government usually holds taxpayers to the form of a transaction when reporting tax results. An exception is where the company can produce “strong proof” that the transaction differs in substance from the labels used to describe it in legal documents.
Two sister companies had a common US parent. One sister company made a loan to the other. Later, they cancelled the loan and replaced it with a smaller amount of preferred stock. When a loan is cancelled, the borrower must ordinarily report “cancellation of indebtedness” income. However, in this case, the taxpayer argued that the cancelled debt was a constructive distribution to the common parent followed by a capital contribution by the parent to the borrower. An IRS agent questioned on audit whether the taxpayer should at least be required to provide “strong proof” of why it should be allowed to ignore its own form for the transaction. The IRS national office responded that transfers of excess consideration between sister companies are a special case where the tax treatment always follows the substance of the transaction regardless of its form. The statement is in a 1993 “field service advice” just made public.
US companies trying to strip earnings from foreign subsidiaries in a form that looks like an equity investment in the US but debt in the foreign country would still be well advised to use neutral terms in the legal papers so as not to have to overcome a “debt form.”