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Jim Fuller |
David Forst |
A somewhat surprising debt-equity case recently filed in the Tax Court involves a loan made to a related US company by a Luxembourg finance subsidiary of Tyco International, then a publicly-held Bermuda company. The Internal Revenue Service (IRS) asserts it has "not been established" that the interest was paid on bona fide debt, but offers no further details. The US borrower's tax court petition states the loan was in the amount of $250 million; the US borrower made all interest payments due on the note; there were proper loan agreements with stated interest rates and a specified repayment schedule; the interest rates, amounts, and maturity dates were consistent with what would ordinarily have been available to the borrower from a third-party lender; and the US borrower had sufficient cash flow to service the debt. Assuming these are the facts, it is quite surprising that the IRS decided that it wants the case in court. These are the primary indicia of bona fide debt.
It is further surprising that the case was initiated by the IRS at all since it lost two major debt-equity cases just last year: NA General Partnership v. Commissioner, T.C. Memo 2012-172 (2012), involving ScottishPower; and PepsiCo v. Commissioner, T.C. Memo 2012-269 (2012). ScottishPower, a UK company, made a loan to its US subsidiary. In PepsiCo, PepsiCo's Netherlands subsidiary issued an instrument to PepsiCo in the US. It will be interesting to see how the Tyco matter unfolds.
In another interesting development regarding an inbound loan by a foreign parent company to its US subsidiary, one which presumably is unrelated to the Tyco matter, the IRS issued Chief Counsel Advice 201334037. The Chief Counsel Advice (CCA) challenges the deductibility of interest paid to the foreign lender under three fact patterns. In Category 1, interest was paid to the foreign parent by netting a required interest payment against the foreign parent's new advance. Category 2 payments involved portions of a new advance by the foreign parent company that were "earmarked" to pay interest on the pre-existing debt in situations in which the interest payment was not netted. Category 3 payments were made close in time to new advances from the foreign parent.
According to the CCA, all three types of claimed interest payments were traceable to new loans or to draw-downs on pre-existing foreign parent lines of credit. The taxpayer (the US subsidiary) argued that correspondence between the times of the advances and its interest payments was not evidence of an economic linkage that could give rise to a deferral of the interest deductions. The taxpayer argued that it could have use or earmarked amounts other than the foreign parent company's advances to pay the interest on its pre-existing foreign-parent debt and correspondingly use the foreign-parent advances for other purposes.
The CCA rejects the taxpayer's arguments and asserts that the payments of interest were not payments for tax purposes since they involved circular cash flows. The CCA cites case law involving circular flows of funds and states that the principles and holdings of this line of cases apply in the context of purported payments of interest when those payments are part of a lender-borrower circular cash flow that may be subject to deferral under section 267(a)(3).
Thus, the interest expense deductions were disallowed on the grounds that the interest was not paid. Under section 267(a)(3), it had to be paid to be deducted. The CCA also states that the IRS will apply a heightened level of scrutiny to potential circular cash flows when related parties are involved and that it will look past the form of the parties' transactions to infer their private intentions from the objective economics of their transactions.
Jim Fuller (jpfuller@fenwick.com)
Tel: +1 650 335 7205
David Forst (dforst@fenwick.com)
Tel: +1 650 335 7274
Fenwick & West
Website: www.fenwick.com
