Indiana Relies on Federal Tax Rules to Recharacterize an Intercompany Loan as Equity

States have the authority to adjust federal taxable income (even if the IRS hasn’t) based on federal tax principles, as Indiana did in this case by recharacterizing debt as equity.

When determining state taxable income, most states use federal taxable income as a starting point, thereby generally conforming to most Internal Revenue Code (“IRC”) provisions. This is done to improve the simplicity of compliance for taxpayers and incorporate the benefits of good federal tax policy into state law. States then apply certain modifications to federal taxable income for IRC provision to which they do not want to conform. Due to this adoption of federal tax laws and policy, states generally reserve the right to adjust a taxpayer’s federal taxable income under federal tax principles, even in cases where the IRS has not.

On Feb. 28, 2018, Indiana published a Letter of Findings in which the state adjusted a corporation’s federal taxable income by denying interest expense based on its determination that the indebtedness was not bona-fide debt but was instead equity under federal tax law and principles.[1]

In this case, a multinational manufacturer of paper tableware engaged in a debt-creating transaction that resulted in one of its U.S. subsidiaries (“Taxpayer”) paying interest to an affiliated company located in a foreign jurisdiction. Taxpayer initially declared a $435 million dividend to its parent company (“Parent”) and paid that dividend by distributing promissory notes to Parent, who subsequently assigned those notes to the foreign affiliate. After this event, Taxpayer began to make payments of interest to the foreign affiliate and deducted this interest expense on its income tax returns. Two facts important to this transaction are that 1) the declared dividend was far in excess of Taxpayer’s accumulated earnings and profits and 2) prior to declaring the dividend, Parent made a $230 million capital contribution to the Taxpayer as forgiveness and discharge of an existing loan.

Under audit, the Indiana Department of State Revenue disallowed the Taxpayer’s interest expense deduction, claiming that the debt giving rise to the interest was not a true indebtedness. Under Indiana law, the state reserves the right to adjust income between two businesses under common control in order to fairly reflect the income derived from sources within Indiana.[2] The state relied on interpretation of applicable federal tax law principles to deny the interest deduction.

When calculating Indiana taxable income, the state conforms to the IRC and adopted Treasury Regulations with only a few exceptions.[3] Under IRC §385, the corresponding Treasury Regulations, and related judicial guidance, federal law sets forth factors that may indicate whether a debt is truly debt or some form of equity. Looking to this statute, Indiana relied on 11 factors[4] to identify the nature of an investment as debt or equity with the weight of each factor dependent upon the facts and circumstances of the case. These factors include (1) the name given to the documents evidencing the indebtedness; (2) the presence of a fixed maturity date; (3) the source of the payments; (4) the right to enforce payments of principal and interest; (5) participation in management; (6) a status equal to or inferior to that of regular corporate creditors; (7) the intent of the parties; (8) “thin” or adequate capitalization; (9) identity of interest between creditor and stockholder; (10) payment of interest only out of the “dividend” money; and (11) the corporation’s ability to obtain loans from outside lending institutions.

Indiana asserted that Parent’s transaction with the Taxpayer did not result in a bona-fide indebtedness, placing importance on four of the factors that indicated the dividend/loan transaction was more akin to a return of capital. First, the source of the repayment was future earnings as supported by the fact that prior loans between Parent and Taxpayer had recently been forgiven due to insufficient earnings to pay the interest and principal. Next, Taxpayer had negative equity for all three years under audit, indicating insufficient capitalization by Parent. Third, Parent’s position as the sole shareholder of Taxpayer’s supported designation as an equity transaction rather than debt. And finally, the state asserted that it is unlikely Taxpayer would have been able to obtain similar loans from an unrelated third party given its negative equity and high debt-to-asset ratio following the transaction. When viewed in whole, Indiana determined that such factors indicated the loans were in fact an equity transaction and thus the corresponding interest was not deductible.

This Letter of Findings shows how states that conform to the IRC can still adjust a company’s federal taxable income through interpretation of federal tax law, even when the IRS itself has neither reviewed nor made its own adjustments. Indiana’s own state law has no direct provision for defining debt or equity transactions, however, through its incorporation of the IRC, the state was able apply its interpretation of federal tax principles.

Aprio’s SALT practice has experience navigating the issues of varying state conformity to federal tax law, including the nuances particular to intercompany transactions, and can advise on the impact of these rules to your business so that you don’t get hit with an assessment and penalties, and also to help you structure your transactions to obtain the intended tax benefits. We constantly monitor these and other important state and local tax issues, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the April 2018 SALT Newsletter. 

[1] Indiana Letter of Findings 02-20160417.

[2] Indiana Code §6-3-2-2(m).

[3] Indiana conforms to the Internal Revenue Code and related Regulations as a specific date which is periodically updated by the state legislature. For the tax years under audit (2011-2013), Indiana followed the IRC as of Jan 1, 2011, for the 2011 tax year and as of Jan 1, 2013, for the 2012 and 2013 tax years.

[4] See Hardman v. United States, 827 F.2d 1409, 1412 (9^th Cir. 1987).