Raising Capital: Navigating Tax Challenges When Classifying Debt Versus Equity
The corporate fundraising environment has changed dramatically this year due to several factors, including a wide sell off in the equity markets, high interest rates, inflation, and a general tightening of the credit markets. Prior to the recent downturn, companies had the luxury of spending to develop their products and marketing ideas first, and then focusing on turning a profit later.
Because of these newly tightened conditions, companies may face challenges when raising capital, forcing them to adopt a more thoughtful approach to seek funding. Likewise, investors will want to ensure their priorities are protected and their returns met. The combination of a given borrower’s need for capital and a financer’s desire to seek favorable returns may lead to the creation of agreements that have characteristics of both debt and equity. As such, it is crucial for all parties involved to understand the resulting tax classification and the treatment of these arrangements, so all expectations are met.
The taxation of debt and equity
For borrowers, the difference between debt and equity can be critical because interest payments are generally tax deductible and subject to certain limitations. Dividends or other payments related to equity would not be deductible for U.S. federal income tax purposes.
Enacted as part of the Tax Cuts and Job Act (TCJA) of 2017, one main limit on interest deductibility is the IRC 163(j) limit on the amount of business interest that can be deducted each year. This limit is calculated as 30 percent of adjusted taxable income, which prior to the 2022 tax year closely resembled earnings before interest, taxes, depreciation, and amortization (EBITDA). However, starting with the 2022 tax year adjusted taxable income excludes depreciation and amortization, becoming EBIT. This should result in a lower limit on the amount of interest expense that can be deducted each year. Any interest expense exceeding this annual limit can be carried forward to future years.
Determining if an arrangement is debt or equity for federal income tax purposes
Classifying an arrangement as debt or equity is made on a case-by-case basis depending on the facts and circumstances of a given agreement. While there is currently little guidance in this area beyond case law, the Internal Revenue Service (IRS) has issued a list of factors to consider when questioning whether something is debt or equity. (Keep in mind, however, that the IRS states not one factor is conclusive.) The factors include whether:
- An agreement contains an unconditional promise to pay a sum certain on demand or at maturity,
- A lender can enforce the payment of principal and interest by the borrower, and
- A borrower is thinly capitalized.
The courts have also established a broader — but similar — list of factors to consider when determining whether an instrument should be treated as debt or equity. Both the IRS and the courts have generally placed more weight on whether an instrument provides for the rights and remedies of a creditor, whether the parties intend to establish a debtor-creditor relationship, and if the intent is economically feasible. Some factors include:
- Participation in management (as a result of advances),
- Identity of interest between creditor and stockholder,
- Thinness of capital structure in relation to debt, and
- Ability of a corporation to obtain credit from outside sources.
For international companies, the characterization of debt or equity when considered in a cross-border funding arrangement is important, as withholding tax rates may apply to interest payments and may differ from tax rates applied to dividends. Further, withholding tax obligations occurs when a cash payment is made. If you have a cross-border arrangement, it is crucial to know if you have debt or equity on your hands.
Special rules related to payment-in-kind
Once it is determined that an agreement should be classified as debt for U.S. federal income tax purposes, some borrowers may prefer to set aside interest payments or pay interest with securities, which is often referred to as payment-in-kind (PIK). This is generally done to preserve cash flow for operations and growth of the business. When a borrower chooses this route, U.S. federal income tax rules will impute an interest payment to the lender.
While using a PIK mechanism will not automatically result in the debt being recharacterized as equity for federal income tax purposes, it can support viewing the instrument as equity.
Limits to deductible debt interest
There are limitations that can apply to interest deductibility. As noted above, IRC 163(j) limits deductibility of business interest; for a corporation, this is deemed to be all interest regardless of use. Another provision that can result in interest deductibility limitation is IRC 163(l), which applies to certain convertible notes and similar instruments held by corporations.
For cannabis operators, it is important to consider that IRC 280E disallows interest deductions. Hence, it is highly detrimental for cannabis operators to issue debt from entities that are cannabis plant-touching.
How we can help
Due to the nature of the debt versus equity analysis, companies thinking about fundraising should plan on how they intend to perform the raise and whether to have the raise treated as equity or debt. If debt classification is desired, a borrower should take the steps needed to strengthen the facts of the transaction to support the arrangement as a debt instrument.
MGO’s dedicated tax team has extensive experience advising companies across industries on capital-raising, debt refinancing and restructuring, recapitalizations, and other tax transactions. If you are planning to fundraise, or you are currently in the process of conducting a debt versus equity analysis, contact us today.
About the authors
Maryam Nicholes is a director and the national leader of MGO’s M&A Tax Advisory Services group. She has more than 13 years of experience advising on a wide range of clients, consulting on structuring and implementation of transactions including mergers, acquisitions and dispositions, global reorganizations, and new investment platforms. She also provides planning and related deal modeling regarding global cash tax exposures, repatriation planning, and related debt structuring and workout. Contact Maryam at MNicholes@mgocpa.com.
Matt Sapowith is a tax partner at MGO. He has more than 14 years of tax planning and compliance experience in areas including corporate and partnership taxation, international tax, M&A transaction advisory, transfer pricing, state and local tax, R&D credit, and compensation planning. He assists companies with structuring for multiple business lines, excise tax and sales tax planning and compliance in a variety of industries including technology, financial services, manufacturing and distribution, professional services, retail and consumer goods, cannabis, and cryptocurrency. Contact Matt at MSapowith@mgocpa.com.