Debt vs. Equity: Understanding the IRS Criteria

1. Chapter 4C. Extra Debt MaterialsEdited December 31, 2010

2. Contents of next few slides Background on Debt and Equity Debt vs. Equity Thin corporations When you may have a debt vs. equity argument with the IRS. Criteria for Debt Earnings Stripping (Read on.)

3. Debt vs. Equity Debt Corporation pays interest to debt holder which is deductible by corporation Interest paid is taxable as ordinary income to individual or corporate recipient (Temporary law provides that individuals use capital gains rates for dividend income.) Loan repayments are not taxable to investors unless repayments exceed basis

4. Debt vs. Equity • Equity: • Corporation pays dividends which are not deductible • Taxable as ordinary income to recipient to extent corp has E & P • Corporate shareholder may receive dividends received deduction

5. Reclassification of Debt As Equity If corp is “thinly capitalized”, i.e., has too much debt and too little equity IRS may argue that debt is really equity and deny tax advantages of debt financing If debt has too many features of stock, principal and interest payments may be treated as dividends

6. Thin Capitalization Factors-1 • Debt instrument documentation • Debt terms (e.g., reasonable rate of interest and definite maturity date) • Timeliness of repayment of debt • Whether payments are contingent on earnings

7. Thin Capitalization Factors-2 • Subordination of debt to other liabilities • Whether debt and stock holdings are proportionate • Use of funds (if used to finance initial operations or to acquire capital assets, looks like equity) • Debt to equity ratio

8. Reclassification of Debt As Equity Four times for dispute: • Investment of assets in a corporation and receipt of stock or debt (351)vs. sale (Rudolph A. Hardman) • Does the investor receive dividends or interest? • Is corporation paying interest or dividend? • At the end, how is repayment or worthlessness treated?

9. Debt or Equity? There is no definition in Code or regs for determining if an interest in a corp. is debt or equity. Characterization as debt or equity is based on case law: numerous factors identify economic substance of an investor's interest.

10. Sec. 1361(c)(5)(B) Straight debt defined… any written unconditional promise to pay on demand or on a specified date a sum certain in money if — (i) the interest rate (and interest payment dates) are not contingent on profits, the borrower's discretion, or similar factors, (ii) there is no convertibility (directly or indirectly) into stock…

11. Classification Criteria

12. Earnings Stripping. Suppose a U.S. parent invests $1,000,000 in stock of a foreign subsidiary. Then the parent borrows that money from the subsidiary at an interest rate of 25%. Parent has interest expense of $250,000 per year on a loan of money [that was the parent’s money]. The foreign subsidiary has interest income of $250,000, but that income is not subject to U.S. taxes until the subsidiary pays a dividend to the parent, which it will not do. This is an aggressive form of earnings stripping, and it is not allowed under the Internal Revenue Code

13. Earnings Stripping 163(j) Limit on Deduction for Interest… (1) Limit. (A) .., no deduction shall be allowed … for disqualified interest paid … by such corp. during such year. Amount disallowed … shall not exceed the corp's excess interest expense for the year. (B) Any amount disallowed … shall be treated as disqualified interest paid or accrued in the succeeding year (and clause (ii) of paragraph (2)(A) shall not apply for .. applying this subsection to the amount so treated).

14. Earnings Stripping 163(j) Limit on Deduction for Interest... (2) Corps to Which Subsection Applies. (A) This subsection shall apply to any corp. for any year if-(i) corp. has excess interest expense for such year, and(ii) the ratio of debt to equity of such corp. as of the close of such year (or on any other day during the year as the Secretary may by regs prescribe) exceeds 1.5 to 1.(iii) …other adjustments prescribed by regs

15. Next Few Slides. Review Compound Interest Concepts and Procedures. • Future value of an investment made today. • Present value (today) of an amount in the future. • Future value of an annuity (series of payments). • Present value of an annuity (series of payments).

16. 1. Make an Investment Today. What is the value in the future (Future value)? I will invest $1,000 in a savings account today (January 1, Year 1). My savings account will earn interest at the rate of 10% per year. How much money will be in the account in 3 years?(December 31, Year 3)?

19. Conclusion. If you invest $1,000 today in a savings account earning 10% interest per year, your account will have a balance of $1,331 in three years.

20. 2. Present value of a payment to be made in the future. I bought computer today. My price is $1,000, payable in 3 years. I do not pay interest on this debt. Assume I normally pay 10% when borrowing money. What is present value (today) of the $1,000 to be paid in 3 years?

23. Conclusion. The seller of the computer should be willing to accept $751.31 in full payment of the computer today, if the seller uses the same interest rate. If the seller invests $751.31 today in a savings account earning 10% interest, the balance in 3 years will be $1,000.

24. 3. Future value of an annuity (periodic payments) I will save $1,000 each year and deposit that amount in a savings account on the last day of each of the next 3 years. My savings account will earn 10% per year. How much money will be in my account at the end of 3 years?

26. Conclusion If I invest $1,000 in a savings account at the end of each year (total deposits of $3,000) the account balance will be $3,310 in three years. [Note this also applies for other business transactions involving periodic payments.]

27. 4. Present value of an annuity (series of payments). I bought computer today. My price is $3,000, payable in $1,000 at the end of year 1, $1,000 at the end of year 2 and $1,000 at the end of year 3.I do not pay interest on this debt. Assume I normally pay 10% on borrowed money. What is present value of the payments?

30. Conclusion The actual purchase price of the computer is $2,486.85, if a discount rate of 10% is used (with annual compounding). A little over $500 is for interest for deferred payment. We use these approaches when computing present values (PV) of lease payments, PV of bonds, PV of potential capital budgeting investments, etc.

31. Next few slides: Bond Pricing What is a discount or premium? How do you compute the price of a bond? Study an illustration of issuing a bond at a discount because its interst rate is less than the market requires.

32. Discount or Premium. Bonds issued at discount or premium. How is the bond price computed? How is the amount of the periodic interest payment determined? The amount of interest expense, and amortization?

33. Discount or Premium. Interest is generally stated as a percent of the balance to be received or paid each year. The compounding period may be less than a year. A savings account that earns 10% compounded semiannually will earn 5% each six months. A bond that is issued for 2 years will have 4 compounding periods if it pays interest every six months.

34. Bond IIlustration – Slide 1 of 16 A corporation issues bonds with a face value of $100,000 on 1-1-06. The bonds mature 2 years later on 12-31-07. The bonds pay interest of 10% per year, payable twice per year ($5,000 each 6 months).

35. Bond IIlustration – Slide 2 of 16 If the market rate for companies with similar credit standing is 10%, the bonds will sell for $100,000 (plus any accrued interest if sold between interest dates).

36. Bond IIlustration – Slide 3 of 16 Assume the market insists on an interest rate of 12% compounded semiannually even though our bonds actually pay only 10% per year. The bonds will sell for less than $100,000. The bonds will sell at a discount to provide additional earnings for the investor beyond the $5,000 interest payments each 6 months.

37. Bond IIlustration – Slide 4 of 16 Both the borrower and the investor (if held to maturity) must amortize bond discount using the constant interest rate method (with semiannual compounding).

38. Bond IIlustration – Slide 5 of 16 How would you compute the amount to be paid for these bonds, if yield is 12%, compounded semiannually? Remember, these 2-year bonds have 4 interest periods.

39. Bond IIlustration – Slide 6 of 16 Please discount the interest payments and principal payment, at 12%, compounded semiannually.

40. Bond IIlustration – Slide 7 of 16 On 1-1-06, issue $100,000 of bonds. On 12-31-07 the bonds will mature. Bonds have stated interest of 10%. Bonds pay interest of $5,000 each 6 months. Bob buys bonds at price to yield 12%, with semi-annual compounding. Compute price paid by Bob by discounting cash flows at 6% per interest period.

43. Bond IIlustration – Slide 10 of 16 Prepare amortization table. Note: The PV factors on preceding page were computed with Excel. These factors are a little more accurate than those taken from tables in a book (because of rounding in the textbook).

46. Bond IIlustration – Slide 13 of 16 How much income is recognized by Bob in first year?

47. Bond IIlustration – Slide 14 of 16 How much income is recognized by Bob in first year? $5,792.09 plus $5,839.62.

48. Bond IIlustration – Slide 15 of 16 How much expense is recognized by the company in the first year? $5,792.09 plus $5,839.62.

49. Bond IIlustration – Slide 16 of 16 How much would the bonds sell for if they pay zero interest? Answer: $79,209.37 (Slide 9 of 16)

50. Bonds redeemed before maturity. How do you record the retirement of bonds prior to maturity? How does it affect the financial statements? Please work the problem on the next page.