Many start-up companies in the U.S. owned by foreign entities have trouble getting external funding in the early stages of growth. It is typical for these foreign-owned businesses to receive funding support from a parent company that will use a combination of equity and debt. It is important to understand the differences between equity vs. debt since the classification will have a direct tax impact on the tax returns of the U.S. company.
Equity vs. Debt
In general, equity involves fundraising by issuing stock (ownership interest) of a company. Unlike some countries that require a minimum capital contribution to set up an entity, there is no minimum capital contribution requirement in the U.S. Capital contribution from a parent company does not impact the income statement of the subsidiary; it generally increases the basis of the foreign parent’s investment in the U.S. subsidiary. If the U.S. subsidiary has earnings and profits in the future, distribution to the foreign shareholder would be considered a dividend and therefore it is generally subject to the withholding tax in the U.S. Analysis is required to determine if there is a tax treaty between the countries and what the applicable withholding tax rate would be.
Debt involves borrowing money to be repaid plus interest payments. Financing operations with debt results in the benefit of applying a U.S. interest expense deduction, and the parent company recognizes interest income in a debt arrangement. Specific tax rules need to be followed to determine how much interest expense deduction is allowed annually for the U.S. taxpayer. Withholding tax is generally required on the interest payment made to a foreign person. The general withholding tax rate is 30% and the rate is often reduced by the tax treaty between the countries.
Potential Challenges From the IRS
It is important to carefully differentiate funding types more specifically in well-kept company accounting records to avoid scrutiny from the IRS as they have become more aggressive regarding the classification of debt versus equity. Under U.S. federal tax legislation, the IRS can reclassify debt as equity and vice versa, but the holder of an interest in a U.S. business is bound by its classification of the investment.
While many foreign companies choose to benefit from designating their investment as a loan to reduce its taxable income by claiming an interest deduction, this can be derailed if the IRS chooses instead to characterize the loan as an equity investment and the payment from the U.S. company to the parent is considered dividends when the U.S. company has earnings and profits. In this case, it might require the U.S. subsidiary to withhold tax on the dividend distribution and fulfill reporting requirements which can lead to substantial penalties and late payment interest because of the larger tax liability.
Common Criteria of a Loan
With the stakes are as high as they are, it is important to be able to distinguish the criteria for what qualifies as debt in the first place. For one, an interest rate is required on the loan as one of the terms—AFR is the minimum interest rate required which is often utilized by the IRS in instances where no interest is charged between the parties involved. Another defining characteristic of a debt involves the credit buying power of the borrower or whether the debtor was solvent at the time the funds were advanced to determine if it is a true debt. To safely secure debt status for the investment, there should be a written agreement containing a fixed loan term with a repayment schedule and records of the payments made in accordance with the terms of the agreement.
Without these terms or seeking repayment, it could be considered a capital investment. If no documentation exists, it could be interpreted by the IRS as a lack of intent for repayment at the time the loan came into existence which is why it is so important to keep records and documents connected to the loan.
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