We will be funding out US expansion with debt funding from our parent entity – are there any restrictions for claiming interest expenses as a deduction against income?
The difference between debt and equity funding
Opening a United States-based corporation to expand your business can provide an excellent revenue stream and worth the investment of the parent company. When a new business opens in the United States there are limited external funding options available. Subsequently, when a subsidiary opens in the US, it is typically funded through either equity or debt from the parent company.
The difference between the two comes down to how and when those funds are repaid. Equity lending is funding supplied in exchange for a share of the business’ future profits. The funds are not paid back per se, but instead the companies or individuals who provide the money to start the business receive shares and are paid dividends on those shares until when or if those shares are sold in the future.
Debt funding is structured like traditional loans, where the business is lent a certain amount of funding with an agreed repayment schedule. While some might argue that starting your business out with debt before it has an opportunity to become profitable, there are some advantages. For the new US-based business, the opportunity to claim any paid interest as a deduction against income for tax purposes. There are rules around claiming this deduction, and the United States IRS has the authority to re-characterize debt as equity and vice versa.
Benefits for the US-based subsidiary to have debt related deductible interest
In general, you can deduct all interest you paid or accrued during a tax year from your income to reduce your tax liability. In order to be eligible, the interest generating debts must be used for the explicit purposes of doing business or trade. The collateral used to secure the loan, if any does not matter and the three criteria for claiming the loan interest as a tax deduction include:
- You are legally liable for that debt
- Both you and the lender intend that the debt be repaid
- You and the lender have a true debtor-creditor relationship
Benefits for the parent company to provide a subsidiary with debt funding
It is also possible for a multinational corporation to lower its corporate tax payments by making the loan to the US-based subsidiary through another affiliate in a country with a lower tax rate. When the income from the interest on the debt is taxed in a country with a lower tax rate, the income is shifted from the US to a lower tax county, reducing the overall tax payments.
This does not apply to multinationals incorporated in the United States, because the business typically pays the full US statutory corporate tax rate on interest payments received by their low-tax foreign subsidiaries during the year that the payments are made. However, for multinationals incorporated outside of the United States, such payments are not taxed by the United States.
Restrictions on claiming interest as a deduction against income
The IRS applies certain criteria to control the amount of interest that can be claimed against US-based income.
The restrictions that apply to non-US multinationals on opportunities to lower tax payments through interest are limited by the deduction of interest expense. Currently, the restriction on a U.S. company’s deduction of interest expense is based on the earnings of the U.S. business in relation to the companies to which it pays interest. The interest must be paid to a related party that is either partially or entirely exempt from US taxation. It is important that there is a written promissory note for the US subsidiary to repay the loan either on demand or on a specific repayment plan including the amount due and due dates.
There are also limitations on the deduction of interest against income for tax purposes related to the US-based company’s debt-to-equity ratio. This figure is determined by dividing the company’s total liabilities by its stockholders’ equity and shows how much debt the company is using to finance its assets in comparison to the value represented by the shareholders’ equity. For a US based business, if the company’s debt-to-equity ratio exceeds 1.5 to 1 and the amount of interest paid minus the amount of interest received exceeds 50% of the company’s adjusted taxable income, then the interest expense over that 50-percent limit cannot be deducted.
Timing is also a consideration and potential restriction for US-subsidiaries using interest payments as a deduction against income. A company can carry forward disallowed interest expense indefinitely to reduce tax liability in future years by not using that interest expense as a deduction until a future year. The company can also carry forward its excess limitation, which is the gap between the company’s level of net interest expense and the allowable level, if the company’s net interest expense is below the allowable level to increase the allowable level of interest expense in any of the three following years.
Another consideration is whether or not the corporation’s stock is convertible. The reason debt funding is an attractive option for parent companies is that it changes the finances to tax deductible interest instead of non-deductible dividends. However, the IRS can re-characterize the interest payments, especially if the corporation can convert its stock.
There are many factors to take into consideration when funding an expansion in the US markets with a US-based subsidiary when it comes to financing and tax liability. Asena offers extensive experience in navigating international tax regulations and can help your company to make the most tax efficient decisions. Consider getting advice from our experienced specialists to help mitigate your tax burden at home and abroad.
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This document is intended as an information source only. The comments and references to legislation and other sources in this publication do not constitute legal advice and should not be relied upon as such. You should seek advice from a professional adviser regarding the application of any of the comments in this document to your fact scenario. Information in this publication does not take into account any person’s personal objectives, needs or financial situations. Accordingly, you should consider the appropriateness of any information, having regard to your own objectives, financial situation and needs and seek professional advice before acting on it. Asena Advisors exclude all liability (including liability for negligence) in relation to your reliance in this publication.