Two Hybrid Debt Instruments

Two Hybrid Debt Instruments

June 01, 2004

Two hybrid debt instruments survived separate IRS audits.

In one of the audits, a US company had injected capital into an offshore subsidiary both by making interest-bearing loans and by advancing other money under “subordinated loan agreements.” The offshore subsidiary was not required to pay interest to its US parent on the subordinated loans. There was no fixed maturity date by when it had to repay the loans. The US company reported the loans as an equity investment in the subsidiary for US tax purposes, but it treated them as debt both for tax purposes in the country where the subsidiary was located and for financial statement purposes.

The reason for the subordinated loans was to avoid a capital tax in the foreign country on capital contributions. No capital tax had to be paid on borrowed money.

IRS agents auditing the US company insisted that the US parent had to treat the subordinated loans as debt for US tax purposes. The US company had labeled them “subordinated loans.” A US company cannot normally disavow the label it chooses for an instrument.

However, the IRS national office overruled the agent in a ruling made public in late April. The agency said the principle that a taxpayer cannot disavow his own form does not apply in this case because the US company consistently reported the instrument as equity on its US tax returns.

The IRS agent tried another argument. The foreign country where the subsidiary is located imputed interest on the loan. It treated the US parent company as if it received interest and then immediately made capital contributions back to the subsidiary in the same amount. Small amounts of capital tax had to be paid as a result. The IRS agent insisted that even if the US company is right that the instruments are equity investments, it must report the income that the foreign country imputes on the instruments. These payments should be reported as dividends on the company’s US tax return.

The IRS national office said nonsense. The fact that a foreign country tax law imputes payments on an instrument does not mean there is income in the US. The ruling is Technical Advice Memorandum 200418008.

In a separate audit, a different US company faced its own challenge to a hybrid instrument. The company injected capital into an offshore subsidiary. It reported the investment for US tax purposes as equity. The offshore subsidiary treated it for local tax purposes as a loan. An IRS agent argued that the US tax code bars such inconsistent treatment. Section 385(c) forbids the holder of an instrument issued by a corporation from characterizing the instrument differently than the corporation did when the instrument was issued, unless the holder discloses the inconsistency on his US tax returns.

The IRS national office rebuffed the agent. It said there was no inconsistency in this case. The companies had reported the instrument all along for US tax purposes as equity.

The ruling is Technical Advice Memorandum 200419001. The text was made public in May.

Keith Martin