Is thin capitalization tested on a book or fair market value basis, and is interest on a loan used to fund a distribution exceeding shareholder equity deductible for Article 9-A?

Plain-English summary

Indopco, Inc. (a Delaware corporation, part of the Unilever group) made two 1990 distributions to its parent. The one at issue: a $700 million dividend in April 1990, when Indopco's book capital was under $50 million but the net fair market value of its assets was independently appraised at about $1.6 billion. To fund it, Indopco borrowed $700 million at an arm's-length market rate from Unilever Capital Corporation, a brother/sister corporation. Delaware law permits a dividend out of revaluation surplus (marking assets up to fair market value), and the borrowing did not impair Indopco's solvency. Indopco asked, for Article 9-A: (1) is thin capitalization tested on a book or fair market value basis, and (2) if it is not thinly capitalized, is the interest on that loan deductible even though the distribution exceeded shareholder equity?

Issue 1 -- thin capitalization is tested on a fair market value basis. The federal debt-versus-equity (thin capitalization) determination -- whether purported debt is really equity because debt far exceeds equity -- is an objective determination made on the fair market value of assets, not book value. On a fair-market-value basis (about $1.6 billion in assets), Indopco was not thinly capitalized.

Issue 2 -- the interest deduction is fact-dependent. Under Treasury Reg. 1.316-1(a), the portion of a distribution that exceeds earnings and profits is not a dividend but a return of capital. Whether the interest on the brother/sister loan used to fund such a distribution is deductible for federal income tax purposes -- and, in turn, for Article 9-A -- depends on whether the loan is bona fide debt with a legitimate purpose and economic substance. That is a factual question that an advisory opinion cannot decide; because it arises in an audit, it will be resolved there.

What this means for you

Thin capitalization is judged at fair market value, not book

When deciding whether debt is really equity, the test looks at the fair market value of the corporation's assets against its debt -- so a company with low book equity but high asset value may still not be thinly capitalized.

A distribution above earnings and profits is a return of capital

Under Treasury Reg. 1.316-1(a), the excess over earnings and profits is not a dividend; it is a return of capital.

Deductibility of the loan interest is a factual, audit-stage question

Whether interest on a related-party loan used to fund an over-equity distribution is deductible turns on whether the loan is bona fide debt with economic substance -- not something an advisory opinion resolves.

Common questions

Q: Is thin capitalization measured on my book numbers?
A: No. It is tested on a fair market value basis. Low book equity does not make you thinly capitalized if your assets' fair market value is high.

Q: My distribution exceeded earnings and profits -- is the excess a dividend?
A: No. Under Treasury Reg. 1.316-1(a), the portion above earnings and profits is a return of capital.

Q: Can I deduct the interest on the loan I used to make the distribution?
A: It depends on whether the loan is bona fide debt with a legitimate purpose and economic substance -- a factual matter decided on audit, not in an advisory opinion.

Citations and references

Statutes, regulations, and authorities:
- Tax Law section 208.9 (entire net income; deductions follow federal taxable income)
- Business Corporation Law section 510 (dividends and distributions out of surplus)
- Treasury Regulation section 1.316-1(a) (a distribution in excess of earnings and profits is a return of capital, not a dividend)
- IRC section 172 and the federal debt-versus-equity (thin capitalization) doctrine

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/corporation_ao_1993.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/corporation/a93_21c.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-93 (21) C
Corporation Tax
December 1, 1993

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. C930519A

On May 19, 1993, a Petition for Advisory Opinion was received from Indopco, Inc., c/o
Unilever United States, Inc. Tax Department, 800 Sylvan Ave., Englewood Cliffs, New Jersey
07632.
The issues raised by Petitioner, Indopco Inc., for purposes of Article 9-A of the Tax Law are
(1) whether thin capitalization is tested on a book basis or a fair market value basis, and (2) assuming
that thin capitalization is determined on a fair market value basis and that the taxpayer is not thinly
capitalized, whether interest paid on a loan used to make a distribution to Petitioner's sole
shareholder is deductible when computing entire net income under Article 9-A even though the
distribution exceeded shareholder equity.
In 1990, Petitioner, a Delaware corporation, made two distributions to its parent, Indopco
Holding, Inc., which is also a Delaware corporation. The first dividend of $400 million occurred in
January, 1990. Although this dividend was made with borrowed funds, Petitioner had retained
earnings in excess of $400 million recorded on its books at the time of the dividend. Nothing with
regard to this first dividend is at issue.
The second dividend of $700 million was made in April, 1990. Immediately preceding the
distribution, the balance of Petitioner's book capital account was less than $50 million, whereas the
net fair market value of Petitioner's assets were independently appraised at approximately $1.6
billion. In order to make the distribution, Petitioner borrowed $700 million at an arm's length,
variable market rate of interest from Unilever Capital Corporation, a brother/sister corporation of
Petitioner. This second dividend was made in accordance with the laws of Delaware. Delaware's
law permits the declaration of a dividend from a revaluation surplus(ie., the marking up of assets
from their book values to their fair market values before declaring a dividend). In order to pay a
dividend based on a revaluation surplus, a corporation may borrow against the fair market value of
its assets. This borrowing did not impair Petitioner's solvency. Following the borrowing, Petitioner
continued to meet its obligations to creditors on a timely basis.
Section 510 of the Business Corporation Law provides, in pertinent part:
(a) A corporation may declare and pay dividends or make other distributions in cash
or its bonds or its property, including the shares or bonds of other corporations, on
its outstanding shares, except when currently the corporation is insolvent or would
thereby be made insolvent, or when the declaration, payment or distribution would
be contrary to any restrictions contained in the certificate of incorporation.
TP-9 (9/88)

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(b) Dividends may be declared or paid and other distributions may be made out of
surplus only, so that the net assets of the corporation remaining after such
declaration, payment or distribution shall at least equal the amount of its stated
capital ....
(c) When any dividend is paid or any other distribution is made, in whole or in part,
from sources other than earned surplus, it shall be accompanied by a written notice
(1) disclosing the amounts by which such dividend or distribution affects stated
capital, capital surplus and earned surplus, or (2) if such amounts are not
determinable at the time of such notice, disclosing the approximate effect of such
dividend or distribution upon stated capital, capital surplus and earned surplus and
stating that such amounts are not yet determinable.
For purposes of the Business Corporation Law, surplus is defined in section 102(a)(13) as
the excess of net assets over stated capital. Surplus consists of earned surplus and capital surplus.
Earned surplus is defined in section 102(a)(6) as that portion of the surplus that represents the net
earnings, gains or profits, after deduction of all losses, that have not been distributed to the
shareholders as dividends, or transferred to stated capital or capital surplus, or applied to other
purposes permitted by law. Unrealized appreciation of assets is not included in earned surplus.
Capital surplus is defined in section 102(a)(2) as the surplus other than earned surplus. Net assets
is defined in section 102(a)(9) as the amount by which the total assets exceed the total liabilities.
Stated capital and surplus are not liabilities. Stated capital is defined in section 102(a)(12) as the
sum of (A) the par value of all shares with par value that have been issued, (B) the amount of the
consideration received for all shares without par value that have been issued, except such part of the
consideration therefor as may have been allocated to surplus in a manner permitted by law, and (C)
such amounts not included in clauses (A) and (B) as have been transferred to stated capital, whether
upon the distribution of shares or otherwise, minus all reductions from such sums as have been
effected in a manner permitted by law.
Accordingly, under the Business Corporation Law Petitioner was not prohibited from making
the $700 million distribution to its parent. However, it does not necessarily follow that such
distribution will be treated as a dividend for franchise tax purposes under Article 9-A of the Tax
Law.
Section 209.1 of the Tax Law provides that the franchise tax is imposed on a business
corporation for the privilege of exercising its corporate franchise, or of doing business, or of
employing capital, or of owning or leasing property in New York State in a corporate or organized
capacity, or of maintaining an office in New York State, for all or any part of each of its fiscal or
calendar years and such tax is measured by the corporations's entire net income base (or other
applicable basis).
Section 208.9 of the Tax Law defines entire net income as total net income from all sources
which shall be presumably the same as the entire taxable income which the taxpayer is required to
report to the United States Treasury Department and is adjusted as required by sections 208.9 and
210.3 of the Tax Law. Section 3-2.2(c) of the Business Corporation Franchise Tax Regulations

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provides that where a corporation participates in the filing of a consolidated return for Federal
income tax purposes, but files a separate return for New York franchise tax purposes, Federal taxable
income is computed as if the corporation had computed its Federal taxable income on a separate
basis for Federal income tax purposes. (See also: Kenneth T. Zemsky, Adv Op Comm T&F, January
31, 1992, TSB-A-92(2)C and Leonard Koval, CPA, Adv Op St Tax Comm, March 16, 1984, TSBA-84(2)C.)
Section 1-2.1 of the Business Corporation Franchise Tax Regulations provides that "Any
term used in [Article 9-A] shall, unless a different meaning is clearly required, presumably have the
same meaning as when used in a comparable context in ... the laws of the United States relating to
Federal income taxes and the Federal tax regulations promulgated thereunder .... "
Accordingly, it must be determined how the issues raised herein would have been treated for
Federal income tax purposes if Petitioner had filed a separate Federal income tax return for taxable
year 1990.
With respect to Petitioner's first question, thin capitalization is an objective determination
made upon the evaluation of a corporation's debt-to-equity ratio. An excessive ratio, one in which
debt far exceeds equity, typically indicates thin capitalization. Because the nature and requirements
of different businesses impose different standards of determining an acceptable debt-to-equity ratio,
there are no "hard and fast rules" for what constitutes an excessive debt-to-equity ratio. However,
"[i]n computing the ratio of debt to equity, the use of market values for the assets (including
goodwill), rather than their cost or book value, is well established ..." (Bittker and Eustice, Federal
Income Taxation of Corporations and Shareholders, 5th Ed.; Warren, Gorham &-Lamont (1987) at
¶4.04, p.4-24). See also, Liflins Corp. v U.S., 390 F.2d 965 (Ct. Cl., 1968) citing, with approval,
Goldstein, "Corporate Indebtedness to Shareholders," 16 Tax L. Rev. 1, 19 (1960): "[t]he prevailing
view seems to be that assets are to be taken at fair market value rather than at book value when
valuing the equity interest in order to compute the [debt-to-equity] ratio."
The use of fair market asset values rather than book values to determine a permissible debt­
to-equity ratio was embraced by the Second Circuit in Kraft Foods Company v Commissioner of
Internal Revenue, 232 F.2d 118, 127 (2d Cir., 1956):
The Commissioner argues that since the transaction in question produced a
disproportionate ratio of debt to capital it would not constitute genuine indebtedness
as against third party creditors, and therefore it should not be treated as indebtedness
against the Government for purposes of determining taxpayer's income tax liability.
... However... it is apparent from the record that no disproportionate ratio of debt to
capital resulted from the issuance of the debentures. We think it obvious that in the
determination of debt-to-equity ratios, real values rather than artificial par and
book values should be applied. See B.M.C. Mfg. Corp., 1952 [11 TCM 376],
Cleveland Adolph Mayer Realty Corp., 1946, 6 TC 730, rev'd on other grounds 160
F2d 1012 (6th Cir., 1947). (emphasis added, footnote omitted).

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Accordingly, the controlling law indicates that for Federal income tax purposes, a
determination of thin capitalization is tested on the fair market value rather than the book value of
a taxpayer's assets.
It appears that the thin capitalization issue is only one factor in determining whether a
transaction is treated as debt or treated as equity. In John W. and Marie B. Dillin v United States,
433 F2d 1097, 1099 (1970), the Fifth Circuit stated:
The problem of determining, in the context of the Internal Revenue Code and modern
business relations, what constitutes an equity interest and what constitutes a debt
interest has been a matter of continuing concern for the courts ....
In Montclair, Inc. v. Commissioner of Internal Revenue, 5 Cir. 1963, 318 F.2d 38,
at page 40, we attempted to list some of the guiding considerations in deciding debt­
equity cases:
"(1) the names given to the certificates evidencing the indebtedness; (2) the presence
or absence of a maturity date; (3) the source of the payments; (4) the right to enforce
the payment 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 'dividend' money; (11) the ability
of the corporation to obtain loans from outside lending institutions."
In applying these factors, each case must be decided on its own unique fact situation
and no single test is controlling. Berkowitz v. United States, 5 Cir. 1969, 411 F.2d
818; Harlan, et al. v. United States, 5 Cir. 1969, 409 F.2d 904; Tomlinson v. 1661
Corporation, 5 Cir. 1967, 377 F.2d 291.
Accordingly, the determination of whether a transaction results in debt or equity, is a factual
question. As shown in Dillin, supra, several factors must be considered, however "each case must
be decided on its own unique fact situation and no single test is controlling".
With respect to Petitioner's second question, the determination of whether the interest
Petitioner paid to Unilever Capital Corporation, a brother/sister corporation of Petitioner, on funds
borrowed to pay a dividend to Petitioner's parent, Indopco Holding, Inc., is deductible under section
163 of the Internal Revenue Code is not easily assertained.
Section 163(a) of the Internal Revenue Code provides that there shall be allowed as a
deduction interest paid or accrued within the taxable year on indebtedness. The United States Court
of Appeals for the Eighth Circuit has stated:

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A debt is "that which is due from one person to another, whether money, goods or
services; that which one person is bound to pay to another, or perform for his
benefit." Webster's New International Dictionary .... The term "indebtedness" as used
in the Revenue Act implies an unconditional obligation to pay. Any definition more
flexible would only encourage subterfuge and deception. (Gilman v Commissioner
53 F 2d 47, 50 (8th Cir 1931)).
In Badi Zohoury and Wilma 3. Zohoury v Commissioner, 46 TCM 1521, Dec. 40,498(M),
TC Memo 1983-597, the Tax Court provides that:
[w]here ... the transaction giving rise to the claimed indebtedness is between family
members, the evidence presented to establish such a debt must be closely scrutinized.
See Woodward v United States 208 F2d 893 (8th Cir 1953); Wales v Commissioner
[Dec 35,077(M)], TC Memo 1978-125, affd without published opinion (9th Cir
1980). The relevant Court decisions dealing with intra-family loans have identified
several factors that have been given weight in determining whether a purported loan
was in fact a bona fide debt. These factors include:
(1) Whether a specific rate of interest is charged to the taxpayer for the use
of the money;
(2) whether there is a specific date for repayment;
(3) whether there is a written instrument evidencing the debt;
(4) whether there is a legitimate purpose for obtaining the loan;
(5) whether the taxpayer intended to repay the debt;
(6) whether the relative receiving the payments on the loan was impecunious;
and
(7) whether the loan has economic substance.
In Georgia Cedar Corp., 55 TCM 853, Dec. 44,777(M), TC Memo 1988-213, a corporation
was disallowed interest deductions taken for payments made on a promissory not because the
transactions involving the note laced economic substance. The note was passed among two wholly
owned subsidiaries, including the taxpayer, and their parent corporation. The corporate taxpayer
failed to prove that its purchase of the note was not part of a preconceived plan to relieve cash flow
problems. No genuine indebtedness existed, and negotiations for the note did not take place at arm's
length.
In an Internal Revenue Service letter ruling, it was held that a transfer of funds between two
commonly controlled foreign shipping subsidiaries, that was characterized as a loan, resulted in a
constructive dividend from the transferor to the parent and in a contribution of capital by the parent
to the transferee. Although the loan bore interest, was a bona fide debt in the opinion of the
transferee's creditors, and was repaid, no debt was actually created for other than the purpose of

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obtaining a tax benefit. Also, no purpose for the transfer other than a desire by the distributing
corporation to invest surplus funds was demonstrated, and such investment rationale was deemed
to be too generalized to be a recognizable business purpose. In addition, the enhanced investment
in the transferee was a benefit to the common shareholder that could not be considered as merely
incidental and effect the negation of the treatment of the transaction as a constructive dividend and
simultaneous contribution of capital to the recipient subsidiary. (IRS Letter Ruling 8207010,
November 10, 1981.)
Herein, the purpose of the loan to Petitioner was to enable Petitioner to pay a dividend to its
parent. However, for purposes of section 316 of the Internal Revenue Code the distribution
Petitioner made to its parent might not be treated as a dividend.
Section 1.316-1(a) of the Treasury Regulations states:
(1) The term "dividend" for the purpose of subtitle A of the [Internal
Revenue] Code ... comprises any distribution of property as defined in section 317
[of the Internal Revenue Code] in the ordinary course of business, even though
extraordinary in amount, made by a domestic or foreign corporation to its
shareholders out of either-­
(i) Earnings and profits accumulated since February 28, 1913,
or
(ii) Earnings and profits of the taxable year computed without
regard to the amount of the earnings and profits (whether of such year
or accumulated since February 28, 1913) at the time the distribution
was made.
The earning and profits of the taxable year shall be computed as of the close of such
year, without diminution by reason of any distributions made during the taxable year.
For the purpose of determining whether a distribution constitutes a dividend, it is
unnecessary to ascertain the amount of the earnings and profits accumulated since
February 28, 1913, if the earnings and profits of the taxable year are equal to or in
excess of the total amount of the distributions made within such year.
(2) Where a corporation distributes property to its shareholders on or after
June 22, 1954, the amount of the distribution which is a dividend to them may not
exceed the earnings and profits of the distributing corporation.
Accordingly, pursuant to section 1.316-1(a) of the Treasury Regulations, the portion of the
dividend that Petitioner paid to its parent that exceeded earnings and profits is not treated as a
dividend but rather as a return of capital. Therefore, it must be determined whether the loan from
Petitioner's brother/sister corporation to make such distribution is a bona fide debt having a
legitimate purpose and economic substance. Such determination is a factual matter that must be
decided before a determination can be made as to whether interest paid on loans used to make a
distribution to Petitioner's sole shareholder where the distribution exceeded shareholder equity is
deductible for Federal income tax purposes and, in turn, deductible for Article 9-A purposes.

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A question of fact is not susceptible of determination in an Advisory Opinion. An Advisory
Opinion merely sets forth the applicability of pertinent statutory and regulatory provisions to "a
specified set of facts." Tax Law, §l71.Twenty-fourth; 20 NYCRR 2376.1(a). Inasmuch as the
question presented here arises within the context of an audit, the necessary factual determination will
be made within such context, in accordance with the principles outlined above.

DATED: December 1, 1993

s/PAUL B. COBURN
Deputy Director
Taxpayer Services Division

NOTE: The opinions expressed in Advisory Opinions
are limited to the facts set forth therein.