Careers
Contact Us
A recent ruling by the Internal Revenue Service (IRS) holds the potential for substantial repercussions for Canadian corporations possessing U.S. subsidiaries. In this blog, our Zeifmans U.S. tax partner, Stanley Abraham breaks down the December 13, 2023 IRS opinion related to a specific taxpayer issue under examination and how it is related to intercompany loan interest rates and explains the possible implications for Canadian corporations with U.S. subsidiaries.
BACKGROUND
As Canadian-based multinational corporations extend their operations beyond the national borders, it is customary for them to establish a U.S. subsidiary to conduct business in the United States. To facilitate the expansion into the U.S., these corporations typically provide financial support in the form of a “loan.” The U.S. takes a dim view of so-called loans from a foreign parent to a U.S. subsidiary. To ensure that the interest on such loans remains tax-deductible, it is imperative that the loan be classified as a bona fide loan. This entails the U.S. subsidiary maintaining a commercially viable debt-to-equity ratio, rendering it creditworthy. Additionally, the loan documentation should embody a written instrument, stipulate a “market rate” of interest, include at least semi-annual payments, and adhere to other criteria typically found in loan agreements with unrelated third parties.
Failure to meet the criteria for a bona fide loan may result in the IRS recharacterizing principal or interest payments on the loan as distributions on equity. The U.S. does not have a “PUC” system similar to Canada where distributions can be applied to equity before earnings. These distributions would be treated as deemed dividends to the extent of earnings (i.e. the higher of accumulated or current) and subject them to dividend withholding of 5% notwithstanding the fact that, often, these earnings are treated as non-taxable distributions of exempt surplus in Canada.
Importance of the IRS Opinion
In the determination of an arm’s length interest rate for the foreign (e.g. Canadian) parent to change the U.S. subsidiary, the subsidiary’s absence of an earnings history would typically require a higher interest rate on an equivalent loan from an unrelated lender. The importance of the IRS’s ruling is that it establishes that an unrelated third-party lender would likely look towards the creditworthiness of the entire group and, thereby, loan at a rate more closely aligned with the higher creditworthiness of the foreign parent.
Example: CANCO organizes a U.S. corporation (“USCO”) which will need $1 million of capital to “get off the ground”. It contributes $250,000 of equity (e.g. common stock) and loans the balance of $750,000 to USCO. Based on its own creditworthiness, USCO might attract a loan/revolving line of credit at a rate of prime plus 5%. However, as CANCO could borrow at a rate at prime plus 1%, the lower of the two interest rates may be used for intercompany loan interest rate.
The IRS’s opinion was specific to a single taxpayer in a specific fact pattern and cannot be used as “general advice.” But, absent contrary guidance, it indicates the IRS’s view of the issue.
If your business has or is considering establishing a U.S. subsidiary, Zeifmans is here to help you manage the ever-changing complex U.S. tax landscape to ensure you are prepared and well-positioned for long-term financial success. If you have any questions, please contact Stanley Abraham at (647) 256-7551 or at info@zeifmans.ca.
