Capitalizing a Business Entity: Debt vs. Equity (Portfolio 702)


R. Arnold Handler, Esq.

Tax Consultant

R. Arnold Handler, Esq.

At a glance

I. Overview: The Hazy Boundaries Between Debt and Equity
II. The New Regulatory Tests Under §385
III. Applying the Multi-Factor Test to Distinguish Debt and Equity for Legal and Tax Purposes
IV. The Debt/Equity Multi-Factor Tax Test Explained
V. Tax-Aggressive Debt-Equity Transactions — Practical Application
V. Consequences of Classification as Debt or Equity


Bloomberg Tax Portfolio, Capitalizing a Business Entity: Debt vs Equity, No. 702, contains an analysis of debt and equity, including both their core differences and the sometimes blurry nature of the boundary between them. The Portfolio extensively examines:

  • The final and temporary debt-equity regulations that were issued on October 21, 2016;    
  • The case-by-case multi-factor test, including its components, that has historically been applied to determine whether an instrument, or advance on open account, constitutes debt or equity for tax (and often legal) purposes; and    
  • The continued viability and significance of the case-by-case multi-factor test under case law alongside the criteria of the debt-equity regulations.

In addition, the Portfolio analyzes the consequences of classification as debt or equity, ranging from interest expense deductions and the dividends received deduction to issues such as qualification for foreign tax credits and existence of a partnership interest. Aggressively tax-motivated transactions are also discussed in the debt-equity context, including the effect that aggressive tax motivation can have on classification. Practical advice is provided throughout the Portfolio.

The Portfolio also discusses additional issues and problems with regard to debt-equity classification, including as hybrid securities and the international implications of debt-equity classification. These international implications include the attention being paid by the OECD to debt-equity classification in the broader context of increasing global vigilance in auditing what is perceived as aggressive international tax planning. Finally, the Portfolio discusses both past attempts by Congress, the Treasury and IRS to make debt-equity classification more uniform and predictable, the enactment of §385 and issuance of Notice 94-47 respectively, which met with limited success at best; and now the latest attempt, which may well be more successful, the issuance on October 21, 2016, of final and temporary regulations under §385.

This Portfolio may be cited as Handler, 702 T.M., Capitalizing a Business Entity: Debt vs Equity.

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