Should you fund a U.S. subsidiary with equity or debt?
Many foreign-owned companies have trouble getting funding in the U.S. during their early stages of growth. Often, they receive funding support from a parent company, in some combination of equity and debt.
If you’re considering expanding into the U.S. to open a foreign-owned subsidiary, make sure you understand the key differences between equity and debt. The classification has a direct tax impact on tax returns for the U.S. company.
What is equity funding?
In general, equity involves fundraising by issuing stock (ownership interest) of a company. Unlike some countries, there is no minimum capital contribution requirement in the U.S.
Capital contribution from a parent company does not impact the income statement of the subsidiary; it generally increases the basis of the foreign parent’s investment in the U.S. subsidiary. If the U.S. subsidiary has earnings and profits in the future, distribution to the foreign shareholder would be considered a dividend and, therefore, subject to a withholding tax in the U.S.
If a tax treaty between countries exists, it could affect the applicable withholding tax rate.
What is debt funding?
Debt involves borrowing money that will be repaid, plus interest payments. Financing with debt allows you to apply a U.S. interest expense deduction, and the parent company recognizes interest income.
Specific tax rules need to be followed to determine how much interest expense deduction is allowed annually for the U.S. taxpayer. Withholding tax is generally required on the interest payment made to a foreign person. The general withholding tax rate is 30%, although it’s often reduced by tax treaties between countries.
Potential challenges from the IRS
Carefully differentiate and document funding types in your accounting records to avoid scrutiny from the IRS. The IRS has become more aggressive regarding the classification of debt versus equity.
Under U.S. federal tax legislation, the IRS can reclassify debt as equity and vice versa, and the holder of an interest in a U.S. business is bound by the IRS’ classification of the investment.
Tax withholding and liability considerations
Many foreign companies designate their investment as a loan to reduce taxable income and claim an interest deduction. However, this can be derailed if the IRS chooses to characterize the loan as an equity investment instead. Then, the payment from the U.S. company to the parent is considered dividends when the U.S. company has earnings and profits. In this case, the U.S. subsidiary may be required to withhold tax on the dividend distribution and fulfill reporting requirements. That can lead to substantial penalties and late payment interest because of the larger tax liability.
Common criteria for debt and loans
With the stakes as high as they are, it’s important to distinguish the criteria for debt.
For one, an interest rate is required on the loan. The applicable federal rate is the minimum interest rate required, and it’s often used by the IRS in instances where no interest is charged between the parties involved.
Another defining characteristic of debt involves the credit buying power of the borrower and whether the debtor was solvent at the time the funds were advanced. To safely secure debt status for the investment, there should be a written agreement containing a fixed loan term, a repayment schedule and records of payments made in accordance with the terms of the agreement.
Without these terms or seeking repayment, a financing arrangement could be considered a capital investment. If no documentation exists, it could be interpreted by the IRS as a lack of intent for repayment at the time the loan came into existence. For this reason, it’s critical to keep records and documents connected to loans.
How Wipfli can help
It takes money to grow — especially internationally. Since equity and debt have different tax consequences, take time to understand the key differences and advantages of each form of funding. Our team is prepared to answer questions about the U.S. tax treatment of equity versus debt. We can help you successfully expand your business globally and navigate international tax and accounting issues along the way. To get started, contact us today.
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