Inter-Company Investments Between Affiliates Of Multinational Enterprises: Applying The Substance-Over-Form Doctrine To Distinguish Equity From Debt

The classification of a financial instrument as “debt” or as “equity” is crucial in applying a wide range of income tax provisions.  “Interest” expenses incurred on “debt,” for example, are deductible in computing a firm’s taxable income, whereas “dividends” paid on the firm’s outstanding “equity” are not.  “Interest” paid by a U.S. corporation to a foreign creditor is generally not subject to U.S. withholding taxes, whereas “dividends” paid on stock held by a foreign shareholder are typically subject to U.S. withholding taxes that range from 5% to 30% of the gross amount of the dividend paid.  And the list goes on . . . .  Not surprisingly, these disparities in tax treatment have inspired a plethora of schemes, many of them successful, designed to disguise equity investments as “debt.”  The urge to do so is perhaps nowhere more intense than in situations where the “debt” of a U.S. corporation is held by a foreign sister corporation located in a tax haven country.  Interest paid or accrued on debt would be deductible in computing the U.S. corporation’s U.S. taxable income, and would thereby permanently reduce the debtor’s U.S. tax liability.  The interest income earned by the foreign creditor would be exempt from both U.S. withholding taxes and income taxes in the foreign tax haven country.  This interdisciplinary case was developed from the facts and circumstances before the U.S. Tax Court in litigation that resulted from the government’s assertion that $975 million in “loans” made by a wholly owned Dutch subsidiary of Laidlaw Transit, Ltd. to several of Laidlaw’s U.S. subsidiaries were in substance “equity.”   As in most debt-versus-equity cases, the stakes were high:  Laidlaw’s U.S. subsidiaries had deducted over $133 million of intercompany “payments” made to their Dutch sister corporation as “interest expense” and the IRS was suing to recover $52 million in back taxes (plus interest and penalties).  This case integrates three disciplines – tax accounting, financial accounting, and finance -- in an easy-to-comprehend, yet rich setting appropriate for general management, finance, and accounting audiences.  It invites students to thoroughly explore the substance-over-form doctrine as it applies to the debt-versus-equity issue, together with many of the tax, financial, accounting, and economic ramifications that flow from an instrument’s classification.  It also provides students with an opportunity to identify the ethical issues that attend the formulation and implementation of many tax minimization strategies and to identify factors that separate legal “tax avoidance” from criminal “tax evasion.”