IRS attacks "double-dips".

• Position: Interest deduction denied where loans treated as equity

In Laidlaw Transportation, Inc., TC Memo 1998-232, the Tax Court ruled in a memorandum opinion that interest paid from 1986 through 1988 by U.S. subsidiaries of a Canadian corporation to a Dutch affiliate was not deductible, because the underlying loans were equity for U.S. tax purposes.

The case confirms that the IRS is continuing to review offshore financing structures, particularly of foreign-owned U.S. companies, and analyzing their debt-to-equity ratios, especially when the financing involves a so-called "double-dip" transaction. It also illustrates that when designing offshore financing structures involving related parties, steps should be taken to ensure that the characteristics of any financial instruments involved in a transaction satisfy all the criteria associated with bona fide debt, to provide the transaction with genuine economic substance and thereby avoid the possibility of equity reclassification.

Laidlaw involved a typical "double dip" transaction. In 1985, a Canadian parent set up a Dutch finance company to finance its U.S. operations--specifically, the Canadian affiliates borrowed and transferred funds to the Dutch company in the form of equity and noninterest-bearing loans. The Dutch company then lent the funds to U.S. subsidiaries. Based on a financing plan designed by Laidlaw's outside accountants, the purpose of all the transfers was to get a "double deduction"--in Canada, for the interest on the Canadian borrowing, and in the U.S., for the interest on the borrowings from the Dutch company--without incurring any significant Canadian or Dutch tax on the Dutch company's interest income. There was no U.S. withholding tax on interest under the U.S.-Netherlands tax treaty in effect at the time. If the interest was deductible in the U.S., it would create exempt surplus (for Canadian tax purposes) in the Dutch company, which could be distributed as a dividend to the Canadian parent, subject only to Dutch withholding tax.

The facts of the case revealed that loans to the U.S. subsidiaries were payable on demand or on fixed maturity dates and provided for interest. The Tax Court accepted that the loans were legally enforceable obligations of the borrowing subsidiaries and in form were debt obligations. Applying the multi-factor approach used in Estate of Mixon, 464 F2d 394 (5th Cir. 1972), to distinguish between debt and equity, the Tax Court, however, ultimately concluded that the advances were equity. Because it found that...