IRS Continues to Target Interest Expense Deductions on Intercompany Debt

Tyco International Ltd. filed a case in the US Tax Court in August 2013, in which the company asserted that it held valid intercompany debt owed to a related party. Tyco received IRS Notices of Deficiency on June 20, 2013 in which the IRS asserted additional taxes of $883.3 million and penalties of $154 million. In a Form 8-K SEC filing on July 1, 2013, Tyco announced that the IRS had asserted in the Notices of Deficiency that substantially all of the company’s intercompany debt originated during the years 1997 through 2000 should not be treated as debt for US federal income tax purposes. The IRS disallowed interest expense and related deductions in the total amount of $2.86 billion on Tyco’s US federal income tax returns. Tyco will have the opportunity to argue the merit of its reported tax position and to contest the IRS’ proposed adjustments in the US Tax Court case.

In 1997, Tyco relocated its headquarters from the United States to Switzerland, which resulted in some intercompany transfers. The IRS also has targeted Ingersoll-Rand PLC which issued intercompany debt in connection with a relocation of its headquarters to Bermuda in 2001. In 2012, the IRS lost two cases, PepsiCo Inc. and Scottish Power Ltd., which involved similar challenges to intercompany debt interest expense deductions.

In order for a US taxpayer to deduct interest expense on a loan, the debt must be a valid bona fide debt obligation. US federal courts have developed various factors which are considered to determine whether a valid debt obligation exists. These factors include the following:

1. Presence or absence of a fixed maturity date
2. Intent of the parties to create a debt
3. Whether the purported creditors are also stockholders
4. Ratio of purported debt to equity in the borrower company
5. Failure of the borrower to repay

When intercompany debt is involved there is a particular scrutiny of the debt to equity ratio of the company that is the issuer of the debt obligation, i.e., the borrower/debtor. If the issuer is thinly capitalized and it has a high debt to equity ratio, then the IRS could recharacterize the debt as equity to deny interest expense deductions for US federal tax purposes.

If the intercompany debt involves a US company and a foreign related party, the US taxpayer is required to use the cash method of accounting for US federal tax purposes with respect to the interest expense. This means that the US company is only allowed to deduct interest expense on the intercompany debt obligation owed to the foreign affiliate in the year in which the interest is actually paid rather than accrued. Cross-border intercompany debt obligations also can implicate other technical rules under IRC Section 163(j) referred to as interest or earnings stripping. That provision imposes another limitation on a US taxpayer’s interest expense deduction when a loan is owed to a foreign person. The purpose of Section 163(j) is to prevent the inequity that is perceived to occur when the interest income of the foreign recipient escapes taxation in the US federal tax system. Another consideration involving cross-border debt obligations is that the US issuer is generally required to withhold 30% US nonresident tax on interest payments to a foreign holder. A US tax treaty with the foreign holder’s country of residence could reduce the applicable US withholding tax rate on the interest payments.

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