Printable versionSend by emailPDF version
October 2, 2013

2013-Issue 40—This edition of Tax Advisor Weekly updates our previous discussion on intercompany debt and outlines recent case law developments in this important area of tax law.

Two months ago, we discussed the practical considerations facing a CFO or tax executive in planning appropriate levels of subsidiary debt and intercompany debt. (See “Intercompany Debt — How Much Is Reasonable?” 2013-Issue 32.) Part of that analysis is the consideration of whether an instrument is characterized as debt or equity. In recent years, several large multinationals have been required to disclose Internal Revenue Service disallowances of billions in interest and related deductions that had been recognized on prior-year federal income tax returns. Often, the grounds for such a disallowance were that the company’s intercompany debt was more properly characterized as equity and, accordingly, that all related interest payments had been improperly deducted for U.S. federal tax purposes. The stakes are big, both for multinational corporations and the IRS with regard to potential adjustments in this area, so it should be no surprise that a number of cases address testing the approach taken by both the taxpayer and the IRS in making this debt versus equity analysis.

Courts have developed a long line of precedent since the 1913 inception of the income tax, providing insights into how to determine whether an instrument should be classified as debt or equity for U.S. income tax purposes. These cases apply a variety of factors to which they incorporate the facts and circumstances surrounding a particular instrument to make this determination. The result of this patchwork of case law has been the development and evolution of factors that may vary from court to court, from circuit to circuit. The number of factors and the weight ascribed to each may vary as well. Most courts apply 11 or more factors in their analyses. Five of the common factors were subsequently proscribed by Congress in Internal Code Section 385, the Code section enabling future Treasury regulations on the topic:

1) Whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s worth, and to pay a fixed rate of interest;

2) Whether there is subordination to or preference over any indebtedness of the corporation;

3) The ratio of debt to equity of the corporation;

4) Whether there is convertibility into the stock of the corporation; and

5) The relationship between holdings of stock in the corporation and holdings of the interest in question.

Because the statute indicated that the list of factors was not exclusive, the judicial differences persist. A consistency rule was added to Section 385 in 1992 to bind taxpayers to the label placed on the face of an instrument at the time of issuance. However, the IRS is afforded great latitude in challenging the characterization of an instrument as debt or equity and is explicitly not bound by the label ascribed to the instrument by the issuer. Given the latitude provided by the statute and emphasis on facts and circumstances, the issue is litigated regularly, and issuers have to rely on inconsistent judicial guidance when seeking to design instruments with a particular characterization.

A trio of cases decided by the Tax Court in 2012 addressed situations in which the IRS challenged the taxpayer’s characterization of its instruments as debt or equity. The Tax Court delivered two opinions in favor of the taxpayer on debt versus equity analyses. In PepsiCo Puerto Rico, Inc. et al. v. Comm’r (TC Memo 2012-269), the taxpayer prevailed in its argument that its instrument should be characterized as equity. Seeking the opposite characterization in NA General Partnership, et al. v. Comm’r (TC Memo 2012-172) (“Scottish Power”), Scottish Power convinced the Court that its instrument should be characterized as debt. In the third decision, Hewlett-Packard Co. v. Comm’r (TC Memo 2012-135), the Tax Court disagreed with the taxpayer, finding that Hewlett-Packard’s instrument actually reflected a debt obligation and was not an equity investment.

Scottish Power provides insight into the Tax Court’s current approach to intercompany financing considerations, highlighting 11 key factors that the Tax Court considered in the case and that companies must consider when entering into intercompany debt arrangements:

1. The name given to the documents evidencing the indebtedness;

2. The presence of a fixed maturity date;

3. The source of the payments;

4. The right to enforce payments of principal and interest;

5. Participation in management;

6. A status equal to or inferior to that of regular corporate creditors;

7. The intent of the parties;

8. “Thin” or adequate capitalization;

9. Identity of interest between creditor and stockholder;

10. Payment of interest out of only dividend money; and

11. The corporation’s ability to obtain loans from outside lending institutions.

Despite the divergent characterizations sought by the taxpayers in PepsiCo and Scottish Power, there were similar factual scenarios that the Tax Court’s opinions focused on that were absent in the Hewlett-Packard case. In both of those former cases, the taxpayer’s acquisition of entities as part of an effort to expand operations across borders necessitated the issuance of the instrument in controversy. Conversely, in Hewlett-Packard, the foreign investment that predicated the instrument was constructed by an investment bank as a product to market to clients so as to generate foreign tax credits. The Tax Court focused on that credit generation as the substance of the transaction to disregard the conflicting form applied by the issuer.

In all three of the cases noted above, the Tax Court focused on whether the taxpayers’ actions were consistent with their intended characterization of the instrument. The Court found that the taxpayer in Hewlett-Packard had failed to act in a manner that a reasonable equity holder would have acted with respect to its subsidiary, and used that finding as the basis of its opinion to discredit Hewlett-Packard’s assertion that its instrument was equity. On the other hand, the efforts of PepsiCo and Scottish Power to adhere to the structure of their instruments were emphasized, and the taxpayers were given some leniency by the Tax Court for the instances in which they did not strictly follow the form of their instrument.

It seems likely that the existence of an ordinary course of business transaction with a strong business purpose contributed to the upholding of the taxpayers’ characterization in PepsiCo and Scottish Power, but the lack of that business purpose in Hewlett-Packardcontributed to the recharacterization of the instrument. An IRS Special Counsel confirmed this following the release of the opinions, stating that “when the primary purpose of a transaction is to get to a tax answer . . . that does affect the analysis.” The three decisions noted above are part of an overall trend across both federal District Courts and the Tax Court that the IRS tends to be successful against taxpayers that entered into transactions with the primary purpose of obtaining a favorable tax answer and lacked a strong business purpose.

Regardless of the motivation for a company entering into an intercompany debt planning transaction, it is important to think through and properly document the transaction. The IRS and state and local taxing authorities are scrutinizing the substance of these transactions and have procedural tools in place to help them identify these issues during audit. Therefore, the disclosure of tax positions regarding debt versus equity classification may be required in two areas. First, the IRS specifically did not exclude these positions from the scope of disclosure required for uncertain tax positions on Schedule UTP in a 2010 announcement. Second, financial statement disclosures of the debt or equity classification position taken on an instrument may also be warranted under ASC 740, the codification of FAS 109, and ASC 740-10, the codification of FIN 48.

Several large multinationals have disclosed in their SEC filings that the IRS had examined the character of their intercompany instruments, something that could result in future rulings and guidance on this issue. For example, in 2007, Ingersoll-Rand PLC disclosed that interest paid on intercompany debt that it had incurred in connection with the company’s inversion had been disallowed by the IRS on the grounds that the instrument was equity. While the IRS later reversed its position, allowing the taxpayer to characterize the instrument as debt, it is safe to assume that Ingersoll-Rand incurred significant costs in defending the audit.

Alvarez & Marsal Taxand Says:

Companies that have in place, or are considering issuing, intercompany debt should ensure they have appropriate support for their intercompany financing arrangements in place prior to or contemporaneous with the transaction. While careful attention must be paid to developments in ongoing disputes, there is already a long line of judicial and statutory precedence that exists to assist a taxpayer in understanding whether the IRS is more or less likely to characterize its intercompany instrument as debt or equity. Despite this precedence, given the subjective nature of applying these factors, as well as changing terms appearing in instruments over time, the takeaway should be that while it may be true that a comprehensive debt-equity analysis and documentation of that analysis prior to entering into a intercompany debt transaction may not provide certainty given the patchwork of precedent and multiple factors subject to judicial interpretation that currently exist, it is worth the time and effort to make that analysis. Therefore, for a CFO or senior tax officer of a multinational, conducting a robust debt equity analysis upfront can go a long way to establishing the facts and intent around the debt instrument in question, while taking the many factors discussed above into account. It may be just enough to keep your company from engaging in costly audit defense or litigation down the road.


Kristina Dautrich Reynolds
Senior Director, Washington D.C.
+1 202 688 4222

Phil Antoon, Managing Director, Gwayne Lai, Senior Director, and Nicole Mahoney, Senior Associate, contributed to this article. 

For More Information:

Juan Carlos Ferrucho
Managing Director, Miami
+1 305 704 6670

Albert Liguori
Managing Director, New York
+1 212 763 1638

Jeff Olin
Managing Director, Chicago
+1 312 601 4240

Other Related Issues

Intercompany Debt  How Much Is Reasonable?

Financing U.S. Affiliates of Foreign Enterprises: Summary of Relevant U.S. Federal Income Tax Rules and Recent Developments

Financing U.S. Operations


As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer. 

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

About Alvarez & Marsal Taxand

Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the U.S., and serves the U.K. from its base in London.

Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisors in 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.

To learn more, visit or