Your innovative CPA will use the doctrine of debt versus equity to save you taxes and to protect your assets. A “doctrine” is a law created by the courts.
Great tax planners decide if their client needs the tax savings of a related party debt or equity. Debt allows income shifting to an entity that has a tax loss or that is taxed at a low rate. The interest rate on a related party debt can be as low as 1% for short-term debt.
If you would like to brainstorm your tax planning, then please call me, Brian Dooley CPA, at 949-939-3414 for a free one-hour consultation with you and your attorney of CPA.
This blog explains the doctrine. With this knowledge, you can work with your innovative CPA.
The doctrine is the subject of many favorable IRS rulings and court cases. Please, be a prudent taxpayer and obtain an IRS private letter ruling for yourself (more on this link).
This blog looks at a Tax Court victory for a sophisticated cross-border debt by a Pepsi Cola Company and a U.S. District Court victory for a small business.
Pepsi wanted to bring money into the U.S. tax-free. America’ international tax law has a tax penalty when a domestic company invests their foreign profits in America. The penalty tax of $363 million was in dispute. The battle was fought in the Tax Court. Here is a link to the Pepsi case. Victory depended upon a high tension tax issue in corporate finance and tax law between equity and debt.
Both equity and debt offer certain advantages. Innovative companies try to have it both ways by devising hybrid securities that look like debt in some circumstances and like equity in others.
Here is what happened. In the 1990s, Pepsi expanded into Eastern Europe and Asia. PepsiCo chose the Netherlands as its home base. The Dutch tax treaties are the best in the world.
Pepsi recorded the transaction as debt on the financial statements for the Dutch company. Also, they reported the transaction as debt on the Dutch tax returns. In the U.S., they treated on the transaction as equity for income tax purposes.
Your tax planning danger is that many CPAs and attorneys believe that a taxpayer is required to pay on the form you use. This is not the law (if your tax advisor needs help, please have him call me, Brian Dooley, at 949-939-3414 for a free consultation) as you will read in the two cases in this blog.
Tax Court Judge Joseph Goeke wrote a 100-page decision. He said that Pepsi “engaging in legitimate tax planning,” created an innovative “hybrid securities.” This means that the security was treated as debt in the Netherlands and under GAAP and equity in the United States for tax planning. For Pepsi, this created a $363 million tax savings.
PepsiCo successfully argued it had an equity stake in its Dutch subsidiaries. Pepsi said that the payments made to the U.S. parent corporation were tax-free returns of its capital investment. The Tax Court agreed.
Now a small business tax case. In Post Corporation versus United States of America, the Justice Department brought out their Top Gun Attorney, Mr. Carr Ferguson.
This case is has a typical small business bookkeeping goof which the IRS tried to turn into a tax assessment. The bookkeeper posted the amount of money invested into the business as a loan. This is common since software such as QuickBooks (which I like), does not have a “paid in capital” or “capital surplus” account.
In this case, there was not a written document or corporate minutes discussing the transactions. Like most small businesses, the owner puts money into the business when bills must be paid.
When the IRS agent saw the loan account on the tax return, the taxpayer was assessed income tax for imputed interest income.
The doctrine of debt versus equity excludes the issue of bookkeeping postings and the reporting of the transaction on a tax return. Why? This would make it too easy for the taxpayer to game the system. It would also violate the doctrine of substance versus form (also known as economic substance).
Meanwhile, the Department of the Treasury had the IRS issue well-written regulations on the doctrine of debt versus equity (found in section 385). The Justice Department never had a chance. The taxpayer cited these regulations and had an easy victory. On this link, you will find the case with some of my notes.