If you are attempting to determine how your related party loan could characterized for US tax purposes, there are a number of considerations you need to take into account. The following discussion is based on an Australian shareholder company funding its US expansion through an LLC.
1. Is the loan instrument valid for US purposes?
The validity of the instrument (and whether it is legally binding on the parties) will be questionable for both US and Australian purposes if there are deficiencies in its execution.
For Australian purposes, section 127 of the Corporations Act 2001 (Cth) provides that a company may execute a document without using a common seal if the document is signed by:
a. two directors; or
b. a director and a company secretary; or
c. for a proprietary company with a sole director who is also the sole secretary, that sole director/ sole secretary.
For US purposes, individual State laws generally permit an LLC’s members to bind LLCs to legal contracts. The terms of the LLC’s Operating Agreement would need to be considered in order to determine who would have the authority to execute agreements on the LLC’s behalf as a representative of the member, or as the “manager” appointed to administer its operations.
2. Classification of the Loan – Debt vs Equity
Assuming that the Loan Agreement is legally binding on the parties, its classification as either debt or equity, has implications for US tax purposes. The US courts and the IRS take the position that “debt” involves an unconditional obligation to repayment of an advance, whereas an “equity” interest subjects the shareholder to the risk of losing it investment if the business fails (Elec. Modules Corp. v. United States, 695 F.2d 1367 (Fed. Cir. 1982).
The characterization of a “loan” instrument requires consideration of all of the facts and the application of the multi-factor test developed by the US Courts and the IRS, along with Treasury Regulation 1.385-2. The leading US tax case in this regard is PepsiCo Puerto Rico, Inc. v. Commissioner T.C. Memo 2012-269, which concerned the characterization of an instrument which the taxpayer claimed to have features that made it equity under U.S. tax law, and debt under Dutch law. The Tax Court applied the multi-factor test to conclude that the advance was equity for US tax purposes. The factors considered were:
a. the names or labels included in an instrument – what does the instrument, even if superficially, evince an intention to be characterized as? How has the “loan’ been disclosed in the borrower’s and the lender’s financial statements?
b. the presence or absence of a fixed maturity date – a fixed maturity date could be indicative of a fixed obligation to repay the advance – a characteristic of a debt obligation;
c. the source of payments – if repayment is conditional on financial performance, this could be a debt characteristic;
d. the right to enforce payments – the right to enforce the payment of interest is one of the requisites of a genuine debt;
e. participation in management as a result of the advances – if the advance gives the lender a right to participate in the decisions of the borrower, this could indicate equity;
f. subordination to other creditors – if the instrument provides for the advance to be secured and to rank ahead of other creditors, this could indicate a genuine debt;
g. the intent of the parties to create a debt – did the parties intend to create a genuine debt, or is repayment subject to the borrower’s speculative foray into the US market?
h. the extent of the creditor’s ownership interest – if the borrower is wholly-owned by the lender, this could indicate an equity arrangement;
i. “thin” or adequate capitalization – if the borrower is thinly capitalized (with a high debt to equity ratio), repayment of the advance may be indicative of a venture capital arrangement rather than a loan;
j. ability to obtain credit from outside sources – would a reasonable outside lender in an arm’s-length transaction have made advances to the borrower on similar terms? This factor requires consideration of the financial condition and business prospects of the borrower. If the borrower is a new entity or thinly capitalized, and the business risks are substantial (making the likelihood of repayment speculative), the advance could be characterized as equity, whereas an advance to an established, adequately capitalized business is more likely to be characterized as debt;
k. the use of the advance – where the advance is used to acquire capital assets, it is more likely to be characterized as equity, whereas its use in meeting daily operating needs may be indicative of indebtedness;
l. the debtor’s failure to repay – repayment of an advance may support its characterization as debt; and
m. the risk involved in making advances – the key consideration here is whether the funds were advanced with reasonable expectation of repayment regardless of the success of the venture or were placed at the risk of the business;
Ensure that your related party funding arrangements appropriately reflect the intentions of the parties, as getting it wrong could create adverse tax consequences that affect the viability of the funding arrangement.
For more information, contact:
Senior Tax Advisor
U.S. Australia Tax Desk