It is often difficult to determine the proper tax treatment for the transfer of funds among related companies, especially when they are closely held, in which case obedience to corporate formalities may be found wanting.

At times, the nature of the transfer is clear, but the “correct” value of the property or service provided in exchange for the transfer is subject to challenge by the government.

In other situations, the amount of the transfer is accepted, but the tax consequences reported by the companies as arising therefrom – i.e., the nature of the transfer – may be disputed by the IRS, depending upon the facts and circumstances, including the steps taken by the related companies to effectuate the transfer and the documentation prepared to evidence the transfer.

One U.S. District Court recently considered the tax treatment of a transfer of funds by a U.S. corporation to a second-tier foreign subsidiary corporation that was made in response to a threat by a foreign government.

Parent’s Dilemma

U.S. Parent Corp (“Parent”) engaged in business in Foreign Country (“Country”) through a subsidiary corporation (“Sub”) formed under Country’s laws. Parent held Sub through an upper-tier foreign subsidiary corporation (“UTFS”).

Sub contracted with an unrelated Joint Venture (“JV”) to provide services to JV in Country. The contract required Parent to extend a “performance guarantee:” if Sub was unable to perform all of its obligations under the contract, Parent would, upon demand by JV, be responsible to perform or to take whatever steps necessary to perform, as well as be liable for any losses, damages, or expenses caused by Sub’s failure to complete the contract.

The contract was not as profitable as Sub had forecast, and it sustained net losses. Sub informed JV that it would not renew the contract and would exit the Country market at the conclusion of the contract.

Between a Rock and . . .

Shortly after Sub’s communication to JV, the Country Ministry of Finance (“Ministry”) advised Sub that the company it was in violation of Country’s Code and, thus, in danger of forced liquidation. Specifically, Sub was informed that it was in violation of a requirement that it maintain “net assets” in an amount at least equal to its chartered capital; it was given one month to increase its net assets, failing which, Country’s tax authority had the right to liquidate Sub through judicial process.

Parent analyzed the ramifications if Sub was liquidated. It believed that if Sub was liquidated, JV would force Parent to finish the contract pursuant to the performance guarantee, and Parent would have to pay a third party to complete the work, which Parent determined would be very costly. It also worried about the potential damage to its reputation if Sub defaulted.

Sub assured the Ministry that it was taking steps to improve its financial condition. Parent decided to transfer funds to UTFS, which then signed an agreement with Parent pursuant to which funds would be transferred by Parent to Sub, “on behalf of” UTFS. It was agreed that the funds would be used by Sub to carry on its activities, and UTFS confirmed that its financial assistance was “free” and that it did not expect Sub return the funds. Parent then made a series of fund transfers to Sub.

Parent claimed a deduction on its tax return for the amount transferred to Sub, but the deduction was disallowed by the IRS.

Parent paid the resulting tax deficiency, and then sought a refund of the taxes paid, contending that the payment to Sub was deductible as a bad debt, or as an ordinary and necessary trade or business expense.

The IRS rejected the refund claim, and Parent commenced a suit in District Court.

Bad Debt?

Parent contended the payment to Sub was deductible as a bad debt. It argued that courts have defined the term “debt” broadly, and have allowed payments that were made to discharge a guarantee to be deducted as bad debt losses. Parent insisted that a payment by the taxpayer in discharge of part or all of the taxpayer’s obligation as a guarantor should be treated as a business debt that become worthless in the year in which the payment was made.

Parent argued that it made the payment to discharge its obligation to guarantee performance on Sub’s contract with JV. Specifically:

  1. Ministry was threatening to liquidate Sub because it did not have sufficient capital;
  2. Liquidation of Sub would have caused it to default on the contract with JV;
  3. That default would have made JV a judgment-creditor and Sub a judgment-debtor;
  4. Sub would have been obligated to pay JV a fixed and determinable sum of money;
  5. Parent guaranteed Sub’s performance, creating a creditor-debtor relationship between them and making Parent liable for Sub’s debts; and
  6. The payment to Sub satisfied the debt created by Parent’s performance guarantee, and Sub’s inability to repay rendered it a bad debt.

The Court Saw it Differently

According to the Court, Parent’s arguments conflated two questions:

  1. Did Parent pay a debt owed by Sub to JV because it guaranteed that obligation? or
  2. Did the transfer of money by Parent (through UTFS) to Sub create a debt owed by Sub to Parent?

The Court answered both these questions in the negative.

The Court explained that a taxpayer is entitled to take as a deduction any debt which becomes worthless in that taxable year. A contribution to capital cannot be considered a debt for purposes of this rule. The question of whether the payment from Parent to Sub was deductible in the year made “depends on whether the advances are debt (loans) or equity (contributions to capital).”

“Articulating the essential difference,” the Court continued, “between the two types of arrangement that Congress treated so differently is no easy task. Generally, shareholders place their money ‘at the risk of the business’ while lenders seek a more reliable return.” In order for an advance of funds to be considered a debt rather than equity, the courts have stressed that a reasonable expectation of repayment must exist which does not depend solely on the success of the borrower’s business.[i]

It was clear, the Court stated, that the advances to Sub were not debts, but were more in the nature of equity. There was no note evidencing a loan, no provision for or expectation of repayment of principal or interest, and no way to enforce repayment. Instead, the operative agreement stated clearly that it was “free financial aid” and would not be paid back to Parent or to UTFS.

The intent of the parties was clear: it was not a loan and did not create an indebtedness. The Court observed that, in fact, it could not be a loan because further indebtedness for Sub would not have solved the net assets and capitalization problems identified by the Ministry. Sub’s undercapitalization also supported the conclusion that this was an infusion of capital, and not a loan that created a debt.

Performance Guarantee?

Parent next argued that the payment was made pursuant to a guarantee to perform because if Sub was liquidated, Parent would be liable for the damages caused by the breach.

The Court agreed that a guaranty payment qualifies for a bad debt deduction if “[t]here was an enforceable legal duty upon the taxpayer to make the payment.” However, voluntary payments do not qualify, it stated.

It was true that Parent executed a performance obligation with JV to guarantee the work would be done. However, Sub never failed to perform its obligations, and JV never looked to Parent to satisfy any requirements under the performance guarantee. The event that triggered the payment was not a demand by JV to perform; instead it was the notice from the Ministry that Sub was undercapitalized and at risk of being liquidated. No money was paid to JV, and no guaranteed debt or obligation was discharged by the payment. Nothing in the performance guarantee legally obligated Parent to provide funds to Sub; it was only required to perform on the contract if Sub could not. After the money was transferred to Sub, both Parent and Sub had the same obligations under the performance guarantee that existed before the transfer. The payment neither extinguished, in whole or in part, Parent’s obligation to guarantee performance, nor reduced the damages it would pay in the event of a default. It also did not impact Sub’s obligations to perform; it merely reduced the risk that Sub would be unable to perform due to liquidation for violation of Country’s legal capitalization requirements. In short, this was not a payment by a taxpayer in discharge of part or all of the taxpayer’s obligation as a guarantor, because there was no discharge of any obligation.

Parent also argued that an advance of money, pursuant to a performance guarantee, that allowed the receiving company to complete a construction project, was a debt that was deductible as a business expense.

Again, the Court pointed out that there was no contractual agreement between Parent and Sub requiring such a payment to Sub or a repayment by Sub. The payment was made to avoid being called to perform on the performance guarantee between Parent and Sub.

The terms of the payments stressed that no debtor-creditor relationship was being created because it was “free financial aid.” Because this was “free financial aid,” Sub owed no such debt to Parent, and Parent had no right to expect repayment of the funds paid. When the payer had no right to be repaid, the Court explained, the transfer of funds was a capital contribution.

Thus, the advance to Sub did not create a debt, did not pay a debt, and was not a payment of a debt pursuant to a guarantee. Therefore, it was not deductible as a bad debt.

Ordinary and Necessary Expense?

Parent next argued that the payment was deductible as an “ordinary and necessary business expense” that was paid or incurred in carrying on its trade or business.

Parent contended that the financial aid was an ordinary business expense to Parent, because it fulfilled its legal obligations under the performance guarantee and avoided serious business consequences if Sub had defaulted on the JV contract. Among those consequences were Parent’s exposure to substantial financial damages, including the loss of Sub’s assets and equipment, as well as severe damage to Parent’s reputation as a reliable service provider in the global market.

The IRS contended that Parent’s contribution of free financial aid to its subsidiary was neither an “expense,” nor was it “ordinary.” The Court agreed.

As a general rule, voluntary payments by a shareholder to his corporation in order “to bolster its financial position” are not deductible as a business expense or loss.

According to the Court, “It is settled that a shareholder’s voluntary contribution to the capital of the corporation . . . is a capital investment and the shareholder is entitled to increase the basis of his shares by the amount of his basis in the property transferred to the corporation.” This rule applies not only to transfers of cash or tangible property, but also to a shareholder’s forgiveness of a debt owed to him by the corporation.

In determining whether the appropriate tax treatment of an expenditure is immediate deduction or capitalization, “a taxpayer’s realization of benefits beyond the year in which the expenditure is incurred is undeniably important.”

Moreover, to qualify for deduction, the expense involved must be ordinary and necessary for the taxpayer’s own business. As a general rule, a taxpayer may not deduct the expenses of another.

The circumstances giving rise to Parent’s “free financial aid” to Sub, the Court continued, bore none of the hallmarks of an “expense.” Parent was under no obligation to make a payment to Sub, but chose to do so to avoid potential future losses. In response to a letter from the Ministry threatening liquidation because of undercapitalization, Parent decided to transfer (through UTFS) cash to Sub. There was no obligation to return the funds, and Sub was not restricted in how it could use them. As a result, Sub recapitalized its balance sheet, reducing its liabilities and increasing its net equity, thereby eliminating the net asset problem identified by the Ministry. Sub was thereby enabled to continue operations and complete the JV contract. Under these circumstances, the transfer of funds by Parent fit squarely within the capitalization principle.

To be sure, Parent did receive other benefits as a result of the recapitalization. By helping Sub avoid liquidation and finish the JV contract, Parent assured not only that Sub’s valuable equipment and technology would be recovered, but also that Parent’s own reputation and future business operations would not be damaged. But these expected benefits were not realized solely, or even primarily, in the tax years at issue. Instead, like any normal capital expenditure, the benefits to Parent were expected to continue into the future, well beyond the year in which the payments were made.

Reputation and Goodwill

Parent argued that the future benefits to its reputation and business operations did not preclude a current expense deduction. It relied upon a line of cases holding that, when one taxpayer pays the expenses of another, the payment may be deductible if the taxpayer’s purpose is to protect or promote its own business interests such as reputation and goodwill.

The Court conceded that there is such an exception to the general rule that a taxpayer may not deduct the expenses of another, that permits a taxpayer to claim a deduction when the expenditures were made by a taxpayer to protect or promote his own business, even though the transaction giving rise to the expenditures originated with another person and would have been deductible by that person if payment had been made by them.[ii]

The Court, however, found that the exception was inapplicable because the “free financial aid” provided by Parent was not tied to any actual expense of Sub, whether deductible or not.

The Court concluded that the fund transfer from Parent to Sub was not deductible as a bad debt, nor was it deductible as an ordinary and necessary expense of the taxpayer’s business. When distinguishing capital expenditures from current expenses, it explained, the Code makes clear that “deductions are exceptions to the norm of capitalization,” and so the burden of clearly showing entitlement to the deduction is on the taxpayer. Parent did not carry that burden.

“Why Don’t They Do What They Say, Say What They Mean?”

The Fixx may have been onto something. If a business plans to engage in a transaction in order to achieve a specific purpose, its tax treatment of the transaction – how it reports it – should be consistent with its intended purpose. Of course, this presupposes that the business has, in fact, considered the tax consequences of the transaction, as any rational actor would have done in order to understand its true economic cost.

Unfortunately, quite a few business taxpayers act irrationally, forgetting the next phrase in the song, that “one thing leads to another.” It is not enough to report a transaction in a way that yields the best economic result – for example, that most reduces the cost of the transaction – and then hope it is not challenged by the government.

Rather, the optimum economic result under a set of circumstances may only be attained by a critical analysis of the transaction and its likely tax outcome. With this information, the business may then consider, if necessary, how to adjust the transaction steps, or to otherwise offset the expected cost thereof.

[i] The Courts have identified a number of factors relevant to deciding whether an advance is debt or equity:

(1) the names given to the certificates evidencing the indebtedness;

(2) the presence or absence of a fixed maturity date;

(3) the source of payments;

(4) the right to enforce payment of principal and interest;

(5) participation in management flowing as a result;

(6) the status of the contribution in relation to regular corporate creditors;

(7) the intent of the parties;

(8) ‘thin’ or adequate capitalization;

(9) identity of interest between creditor and stockholder;

(10) source of interest payments;

(11) the ability of the corporation to obtain loans from outside lending institutions;

(12) the extent to which the advance was used to acquire capital assets; and

(13) the failure of the debtor to repay on the due date or to seek a postponement.

[ii] The IRS argued that, even under this exception, the taxpayer’s expenditure must be linked to an underlying current expense of the other business; the expenditure at issue had to be earmarked to pay an obligation or extinguish a liability owed to a third party.