The IRS has always been concerned with issues of thin capitalization, debt versus equity characterization and interest deductibility. IRS examiners are increasingly scrutinizing activity related to intercompany debt arrangements and transactions. This focus is consistent with a series of changes that the IRS has initiated over the last two years to establish a more robust international tax and transfer pricing practice.
The IRS utilizes factors established in relevant case law in order to test the validity of an intercompany debt arrangement. These factors include, but are not limited to, whether:
- An arm’s length rate of interest was charged and interest payments were made ;
- The debt is evidenced by written documents such as notes ;
- The debt has a fi xed maturity date and scheduled payments ;
- 4) There is an expectation that he debt will be repaid with free working capital ;
- Security is given for the advances ;
- The borrower is adequately capitalized ; and
- The borrower is able to obtain adequate outside financing from third party sources.
While no one particular factor or set of factors is controlling, the case law has established that the objective facts of a taxpayer’s situation must indicate the intention to create an unconditional obligation to repay the advances. Although the courts consider both the form and economic substance of the advance, the economic substance is more important. The more a related party fi nancing arrangement resembles a loan that an external lender would make to the borrower, the more likely the advance will be considered debt.
The analysis by the IRS is a comparison of intercompany debt to third party fi nancing arrangements. The approach is encapsulated in the standard “Debt vs. Equity” Information Data Request (IDR) that the IRS has developed. This 13-part IDR (with one part containing 16 sub-sections) requires a massive amount of information, including fi nancial data for years outside of the exam. In addition to the IDR, the agent is also required to involve the IRS Chief Counsel attorneys and other designated specialists in developing the issues relevant to a taxpayer’s intercompany debt.