This case, NA General Partnership & Subsidiaries v. Commissioner, T.C. Memo. 2012-172 (June 19, 2012), is also interesting in that it appears to be one of the first to involve a "reverse hybrid" structure.
The parent of the U.S. group was a general partnership which had elected to be treated as a corporation for U.S. tax purposes. The general partnership borrowed substantial amounts from its foreign owners to complete an acquisition of a U.S. subsidiary.
In the years following the issuance of the debt, the partnership was often late in making interest payments. The interest payments were occasionally funded through additional loans from the foreign owners or were simply made through book entries. Within three years, all the debt was effectively contributed to the capital of the partnership.
The Internal Revenue Service was of the view that the advances should simply be treated as capital contributions from the outset, and that the partnership never had the ability or intention to fully repay the advances as if they were debt.
Tax Court's analysis
In its assessment of whether the advances should be treated as debt or equity for tax purposes, the Tax Court relied upon the following 11 factors used by the 9th Circuit court, which would hear any eventual appeal, in its analysis:
- The name given to the documents evidencing the indebtedness
- The presence of a fixed maturity date
- The source of the payments
- The right to enforce payments of principal and interest
- Participation in management
- A status equal to or inferior to that of regular corporate creditors
- The intent of the parties
- "Thin" or adequate capitalization
- Identity of interest between creditor and stockholder
- Payment of interest only out of "dividend" money
- The corporation's ability to obtain loans from outside lending institutions.
Of the 11 factors, the court found only one factor, identity of interest between creditor and stockholder, as being indicative of equity. The court reached this conclusion even though some interest payments were made from advances from the parent, in one case through book entries, and that the principal amount of the advances were ultimately contributed to capital, rather than repaid.
Crucial to the favourable decision was the documentation of the intent of the parties at the time of the acquisition, cash flow projections that showed the general partnership expected to have sufficient cash flow to service the debt, the documentation of the general partnership's ability to borrow comparable amounts from a third-party lender, and substantial compliance with the terms of the loan over the time it was outstanding.
KPMG observation — Reverse hybrid entity
Also of interest in the case is that the structure employed by the taxpayer involved a "reverse hybrid entity", which is an entity that is treated as a corporation for U.S. federal income tax purposes but a flow-through for foreign tax purposes.
While the Tax Court's opinion did not state explicitly that the general partnership was considered a flow-through entity for U.K. tax purposes, that it was so considered is implicit in the description of the facts; particularly the fact that a restructuring undertaken in 2002 was in response to new regulations denying treaty benefits to reverse hybrid entities.
Reverse hybrid structures have been commonly used by Canadian corporations investing into the U.S., although they are less beneficial under the current Canada-U.S. income tax treaty.
For more information, contact your KPMG adviser.