Reprinted from British Tax Review Issue 5, Sweet & Maxwell 100 Avenue Road Swiss Cottage London NW3 3PF (Law Publishers)

Transcription

1 Reprinted from British Tax Review Issue 5, 2013 Sweet & Maxwell 100 Avenue Road Swiss Cottage London NW3 3PF (Law Publishers)

2 Current Notes Debt-equity litigation returns to US courts Introduction For a while it seemed as though the US Internal Revenue Service (IRS) had backed away from litigating debt-equity cases in the US. However, that is certainly no longer the case as recent years have seen a significant increase in the number of debt-equity controversies between taxpayers and the IRS. Indeed, in 2011 the IRS Commissioner stated that inbound financing, which is often used by a foreign group to strip income through interest deductions or parental guarantee arrangements, is one of the major issues on which the IRS is focusing its attention. 1 Some think the recent uptick in activity is due to the fact that issuers became increasingly aggressive in their debt-equity planning following years of relative quiet on the IRS debt-equity front. 2 Others attribute it to the explosive growth in cross-border financing and an IRS concern that outbound interest payments may present a systemic threat to the US corporate tax base. 3 Whatever the cause, the effect is clear: debt-equity litigation in the US is back. The good news for taxpayers is that, as a general matter, the IRS has been losing the recent round of debt-equity cases. 4 In NA General Partnership and Subsidiaries v Commissioner (ScottishPower) 5 the US Tax Court upheld the taxpayer s characterisation of intercompany notes as debt, and in Pepsico Puerto Rico, Inc. v Commissioner (Pepsico) 6 the US Tax Court upheld the taxpayer s characterisation of intercompany advance agreements as equity. Thus, the IRS has lost both sides of this issue. However, the bad news is that the IRS seems entirely undiscouraged by its losses and the pipeline of debt-equity cases shows no signs of running dry. For example, the writers recently resolved a significant debt-equity case at the IRS examination level where almost $3 billion in tax, penalties and interest was potentially at stake (in that case, the IRS conceded the issue in its entirety). 7 Even more recently, several former US subsidiaries of Tyco International Ltd (Tyco) recently initiated litigation to challenge the IRS disallowance 1 D.H. Shulman, Former Commissioner of the US Internal Revenue Service, Prepared Remarks Before the IRS/George Washington University 24th Annual Institute on Current Issues in International Taxation (December 15, 2011). 2 See T. Gilroy, Increased IRS Litigation of Debt-Equity Cases Prompted by Aggressive Issuers, Official Says (2012) 236 BNA Daily Tax Report G-8 (quoting Stephen Larson, IRS Associate Chief Counsel (Financial Institutions & Products)). 3 T.D. Greenway and M.L. Marion, A Simpler Debt-Equity Test (2012) 66 Tax Lawyer 73, 93, In addition to pure debt-equity cases, courts have also recently considered the debt-equity issue in other contexts, particularly with respect to so-called foreign tax credit generator transactions. See, e.g. Hewlett-Packard Company v Commissioner (2012) 103 TCM (CCH) 1736 (TC); Pritired 1, LLC v United States (2011) 816 F.Supp. 2d 693 (SD Iowa). In contrast to the former, the IRS has generally been winning the latter cases. 5 NA General Partnership and Subsidiaries, Iberdrola Renewables Holdings, Inc. & Subsidiaries (Successor in Interest to NA General Partnership & Subsidiaries), Petitioner v Commissioner of Internal Revenue, Respondent (2012) 103 TCM (CCH) 1916 (TC). 6 Pepsico Puerto Rico, Inc. v Commissioner of Internal Revenue (2012) 104 TCM (CCH) 322 (TC). 7 In this note, $ refers to US dollars. 597

3 598 British Tax Review of approximately $2.86 billion in interest and related deductions due to an IRS recharacterisation of intercompany loans as equity. 8 Tyco believes that if it loses that case, the IRS may very well attempt to disallow an additional $6.6 billion of interest deductions for subsequent tax years. 9 Debt-equity analysis in the US The distinction between debt and equity has a rather muddled history in the US. Much of the problem is due to the fact that neither the US Internal Revenue Code (IRC) nor the regulations issued by the US Treasury Department (Treasury) provide definitions of debt or equity. Recognising the uncertainties and difficulties which the distinction between debt and equity has produced in numerous situations, the US Congress attempted to provide some clarity by enacting IRC section 385 in IRC section 385(a) authorises the Treasury to issue regulations setting forth factors for determining whether an interest in a corporation constitutes debt or equity and IRC section 385(b) provides a non-exclusive list of factors that could be included in such regulations. Although the Treasury eventually issued regulations in the early 1980s, those regulations were quickly withdrawn and have not been heard from since. 11 More than a decade after the Treasury withdrew the IRC section 385 regulations, the IRS became concerned that corporations were issuing financial instruments that were designed to be treated as debt for US tax purposes but as equity for regulatory, rating or financial accounting purposes. In order to provide guidance to IRS examiners and taxpayers, the IRS issued IRS Notice which, similarly to IRC section 385(b), provides a non-exclusive list of factors that may be considered in determining whether an advance constitutes debt or equity. 12 Most importantly, however, over time US courts have developed a substantial body of case law which identifies various factors that should be considered as part of a debt-equity analysis. 13 Courts typically weigh these debt-equity factors to determine whether, on balance, the debt or the equity features of an advance predominate. Importantly, because of the fact-intensive nature of the analysis, no one factor is controlling and not every factor is relevant in any particular case. 14 As discussed below, these debt-equity factors were front and centre in both ScottishPower 15 and Pepsico, 16 which demonstrates how the same factors can be used to support either debt or equity treatment. 17 In addition, because the IRS has been arguing both sides of the issue, in some 8 See, e.g. Petition, Tyco Electronics Corp v Commissioner (July 22, 2013) No (TC). 9 See Tyco International Ltd, US Securities and Exchange Commission Form 8-K (July 1, 2013). 10 See US Senate Report No , 138 (1969). 11 See IRS Treasury Decision 7920, CB IRS Notice 94-47, CB See, e.g. Hardman v US (1987) 827 F.2d 1409 (9th Cir) (identifying 11 factors); Estate of Mixon v US (Mixon) (1972) 464 F.2d 394 (5th Cir) (identifying 13 factors); Fin Hay Realty Co v US (1968) 398 F.2d 694 (3rd Cir) (identifying 16 factors). These factors are often referred to as the Mixon factors. 14 See, e.g. John Kelley Co v Commissioner (1946) 326 U.S. 521 (S Ct) In contrast to the factor-by-factor analysis in ScottishPower, above fn.5, (2012) 103 TCM (CCH) 1916 and Pepsico, above fn.6, (2012) 104 TCM (CCH) 322 (discussed below), other courts have considered the debt-equity factors within the framework of broader considerations, such as whether there was: 1. the intention to create a debt; 2. a reasonable expectation of repayment; and 3. the economic reality of actually creating a debtor-creditor relationship. See, e.g. Nestle Holdings, Inc. v Commissioner (Nestle) (1995) 70 TCM (CCH) 682, (TC).

4 Current Notes 599 situations taxpayers may try to use the IRS s arguments for one position against the IRS when it is arguing for the opposite position. Some of these situations are highlighted below. ScottishPower upholds the taxpayer s debt characterisation In the late 1990s, ScottishPower plc (SPPLC), a UK company, formed NA General Partnership & Subsidiaries (NAGP) in the US to acquire PacifiCorp & Subsidiaries (PacifiCorp). In connection with the acquisition, SPPLC advanced nearly $5 billion of its own stock to NAGP in exchange for a combination of fixed and floating-rate notes. Thereafter, NAGP used the SPPLC stock as consideration in the PacifiCorp acquisition. NAGP treated the notes as debt and claimed interest expense deductions in the US. 18 However, at times NAGP needed short-term borrowing to cover interest payments on the notes and some of the notes were eventually capitalised prior to maturity. The IRS examined NAGP s US tax return and asserted that the notes should be characterised as equity for US tax purposes. In ScottishPower, 19 the court considered each of the following debt-equity factors to determine whether the notes were more properly characterised as debt or equity: 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 capitalisation; 9. identity of interest between creditor and stockholder; 10. payment of interest only out of dividend money; and 11. the borrower s ability to obtain loans from outside lending institutions. 20 After finding that the first four factors supported debt treatment and the fifth factor was neutral (that is, it supported neither debt treatment nor equity treatment), the court turned to the sixth factor (a status equal to or inferior to that of regular corporate creditors) and found that it supported debt treatment because the notes were not contractually subordinate to NAGP s general creditors. Significantly, the court gave no weight to the IRS s argument that the notes were structurally subordinate to PacifiCorp s creditors due to the fact that NAGP (the issuer of the notes) was merely a holding company which was entirely dependent on its operating subsidiary (PacifiCorp) to provide the necessary cash flow to service the notes. 21 In particular, the court explained that: With holding companies, any debt issued is necessarily subordinated to the creditors of its operating company. Accordingly, this type of subordination is to be expected and does not in and of itself cast doubt on the legitimacy of debt issued by a holding company. 22 The writers believe this is the first time a court has addressed the issue of structural subordination in the context of a debt-equity analysis. 18 While the court did not discuss the issue, the writers believe SPPLC likely claimed a deduction in the UK for the interest paid by NAGP on the basis that NAGP was a partnership for UK tax purposes ScottishPower, above fn.5, (2012) 103 TCM (CCH) 1916, 1919 (citing Hardman v US (1987) 827 F.2d 1409, 1412 (9th Cir)). 21 ScottishPower, above fn.5, (2012) 103 TCM (CCH) 1916, ScottishPower, above fn.5, (2012) 103 TCM (CCH) 1916, 1921.

5 600 British Tax Review The court s analysis of the seventh factor (the intent of the parties) is also significant. In particular, the court rejected the IRS s argument that the parties tax avoidance motives of capitalising NAGP with intercompany debt in order to obtain interest expense deductions in the US indicated that the notes were more properly characterised as equity. 23 Instead, the court recognised that tax considerations permeate the decision to capitalize a business enterprise with debt or equity and concluded that, if anything, an intention to obtain interest expense deductions by capitalising a subsidiary with debt provides support for the conclusion that the parties intended to create debt rather than equity. 24 In addition, the court discounted the IRS s argument that NAGP s additional short-term borrowing to cover interest payments (as well as the eventual capitalisation of some of the notes) demonstrated that the parties never intended a true debtor-creditor relationship, which is significant as the IRS often emphasises that lack of repayment supports equity treatment. As a result, the court found that the seventh factor supported debt treatment. Thereafter, the court found that the eighth factor ( thin or adequate capitalisation) supported debt treatment, the ninth factor (identity of interest between creditor and stockholder) supported equity treatment and the tenth factor (payment of interest only out of dividend money) supported debt treatment. The court then turned to the eleventh factor (the borrower s ability to obtain loans from outside lending institutions) and observed that the proper question was whether the terms of the notes are a patent distortion of what would normally have been available to NAGP in an arm s-length transaction. 25 As a result, the court gave little weight to the analysis of the IRS s expert witness who had sought to answer the question of whether NAGP could have obtained third-party financing on the same terms and at the same price as the notes from SPPLC. 26 Instead, relying on the conclusion of NAGP s expert witness, the court found that the terms of the fixed-rate notes were not a patent distortion of what NAGP could have otherwise borrowed from third-party lenders. As such, the court determined that the eleventh factor supported treating the fixed-rate notes as debt. 27 In contrast, the court found that the eleventh factor was neutral with respect to the floating rate notes because there was no evidence that NAGP could have obtained third-party financing on terms that were comparable to those of the floating-rate notes. 28 Having completed its factor-by-factor analysis, the court ultimately held that, in view of the case as a whole, the notes were properly characterised as debt for US tax purposes. Although the court made clear at the outset that its objective was not to count the factors, but rather to evaluate them, 29 it is nevertheless worth observing that, in the end, the court found eight debt factors, one neutral factor, one factor that pointed to debt for the fixed-rate notes but was neutral with respect of the floating-rate notes and only a single equity factor. 23 ScottishPower, above fn.5, (2012) 103 TCM (CCH) 1916, ScottishPower, above fn.5, (2012) 103 TCM (CCH) 1916, ScottishPower, above fn.5, (2012) 103 TCM (CCH) 1916, Courts do not apply a mechanical test of absolute identity between the related-party advances and the debt that actually or hypothetically would have been available [from an unrelated lender]. Nestle, above fn.17, (1995) 70 TCM (CCH) 682, ScottishPower, above fn.5, (2012) 103 TCM (CCH) 1916, ScottishPower, above fn.5, (2012) 103 TCM (CCH) 1916, With respect to the floating-rate notes, it is unclear why the absence of such evidence led the court to find that the eleventh factor was neutral rather than supportive of equity treatment. 29 ScottishPower, above fn.5, (2012) 103 TCM (CCH) 1916, 1919.

6 Current Notes 601 PepsiCo upholds the taxpayer s equity characterisation In the mid-1990s, Pepsico, Inc. (Pepsi) undertook a global restructuring of its international business operations due, in large part, to an adverse change in the tax treaty between the US and the Netherlands Antilles. As part of the global restructuring, certain of Pepsi s US subsidiaries (collectively, the US transferors) transferred notes that had been issued by other of Pepsi s US subsidiaries (collectively, the US borrowers) to two of Pepsi s newly formed Dutch subsidiaries in exchange for advance agreements. Under the new structure, the US borrowers made outbound interest payments on the notes to the Dutch subsidiaries which, in turn, paid a preferred return (subject to various contingencies and limitations) on the advance agreements to the US transferors. For various tax planning reasons, Pepsi sought to treat the advance agreements as debt in the Netherlands and as equity in the US. 30 In an effort to secure the desired Dutch tax treatment, Pepsi obtained a ruling from the Dutch tax authority. The IRS examined Pepsi s US tax return and, in contrast to its position in ScottishPower, 31 asserted that the advance agreements should be characterised as debt for US tax purposes. At the outset, it is important to note the postural difference between ScottishPower 32 and Pepsico. 33 In particular, whereas the IRS argued that the intercompany financing in ScottishPower 34 should be characterised as equity, the IRS argued that the intercompany financing in Pepsico 35 should be characterised as debt. The court in Pepsico 36 recognised this role reversal, observing that In a typical debt-versus-equity case, the Commissioner argues for equity characterization whereas the taxpayers endeavor to secure debt characterization. 37 Nevertheless, the court explained that This different twist to the usual fact pattern does not require us to apply different legal principles. 38 Importantly, because the same legal principles apply, the writers believe the IRS is taking a (perhaps unavoidable) risk by litigating both sides of the debt-equity issue (that is, by arguing for debt treatment in some cases while, at the same time, arguing for equity treatment in others). In particular, the writers foresee situations in which taxpayers will attempt to use arguments made by the IRS while on one side of the issue against the IRS when it is on the other side of the issue. Indeed, in recognition of this possibility (albeit not specifically in the debt-equity context), the IRS specifically counsels its lawyers to: [T]ake cognizance of the fact that a position taken solely to win a case against one taxpayer may in the future be used by other taxpayers against the [IRS] Pepsi was effectively attempting to obtain a double dip whereby it would create two deductions (one in the US and one in the Netherlands) at the cost of only a single inclusion (in the Netherlands) Pepsico, above fn.6, (2012) 104 TCM (CCH) 322, 335 fn Pepsico, above fn.6, (2012) 104 TCM (CCH) 322, 335 fn.48 (quoting Segel v Commissioner (1987) 89 TC 816, 826 (TC)). 39 IRS Internal Revenue Manual s (2).

7 602 British Tax Review In Pepsico, 40 the court considered each of the following debt-equity factors to determine whether the advance agreements were more properly characterised as debt or equity: 1. names or labels given to the instruments; 2. presence or absence of a fixed maturity date; 3. source of payments; 4. right to enforce payments; 5. participation in management as a result of the advances; 6. status of the advances in relation to regular corporate creditors; 7. intent of the parties; 8. identity of interest between creditor and stockholder; 9. thinness of capital structure in relation to debt; 10. ability of the corporation to obtain credit from outside sources; 11. use to which advances were put; 12. failure of debtor to repay; and 13. risk involved in making advances. 41 After finding that the first factor (names or labels given to the instruments) was neutral, the court found that the second factor (presence or absence of a fixed maturity date) supported equity treatment. In particular, the court found that the 40-year term of the advance agreements (which could be unilaterally extended for an additional 15 years) was unreasonable given the uncertain financial future of the Dutch issuers. Moreover, the court refused to dismiss the possibility that the advance agreements would become perpetual upon the occurrence of certain events. Importantly, the IRS s argument to the contrary (that is, that the term was reasonable and that the possible perpetual duration of the advance agreements should be ignored) may prove to be an example of an argument that taxpayers will attempt to use against the IRS in situations where the roles are reversed (that is, where the taxpayer is arguing that a 50-year term supports debt treatment). Thereafter, the court found that the third factor (source of payments) supported debt treatment, the fourth factor (right to enforce payment) supported equity treatment and, as in ScottishPower, 42 the fifth factor (participation in management as a result of the advances) was neutral. The court also found that the sixth factor (status of the advances in relation to regular corporate creditors) supported equity treatment. With respect to the seventh factor (intent of the parties), the court found that the parties intent supported equity treatment. Importantly, the court referred to Pepsi s desire to obtain hybrid treatment with respect to the advance agreements (that is, debt in the Netherlands and equity in the US) as legitimate tax planning and, as in ScottishPower, 43 recognised that [t]ransactions are often purposefully structured to produce favorable tax consequences. 44 In this regard, it is interesting to contrast Pepsico 45 with Laidlaw Transportation, Inc. v Commissioner (Laidlaw), a debt-equity case in which the taxpayer sought to treat intercompany notes as debt in the US despite having made representations to the Canadian tax authority that the intercompany notes were equity. 46 Whereas the court in Pepsico 47 found that the parties intention to obtain hybrid treatment supported the taxpayer s characterisation of the advance agreements for US tax Pepsico, above fn.6, (2012) 104 TCM (CCH) 322, 335 (citing Dixie Dairies Corp v Commissioner (1980) 74 TC 476, 493 (TC)) Pepsico, above fn.6, (2012) 104 TCM (CCH) 322, 342, 343 fn Laidlaw Transportation Inc. v Commissioner (Laidlaw) (1998) 75 TCM (CCH) 2598 (TC). 47

8 Current Notes 603 purposes, 48 the court in Laidlaw found that the taxpayer s conflicting assertions to the IRS and the Canadian tax authority undercut the taxpayer s characterisation of the intercompany notes for US tax purposes. 49 The difference may very well be attributable to the fact that the taxpayer in Pepsico engaged in significant discussions with the Dutch tax authority regarding the desired hybrid treatment prior to issuing the advance agreements (going so far as to obtain a Dutch tax ruling), 50 whereas the taxpayer in Laidlaw engaged with the Canadian tax authorities in the context of an audit that occurred after the issuance of the intercompany notes. 51 Next, the IRS asserted (and the court found) that the eighth factor (identity of interest between creditor and stockholder) was not relevant to the debt-equity analysis because all parties to the advance agreements were commonly controlled. 52 In contrast, recall that in ScottishPower the IRS argued (and the court found) that the identity of interest between creditor and stockholder supported equity treatment. 53 What accounts for the difference? To begin, courts generally find that an advance made by stockholders in proportion to their respective stock ownership tends to support equity treatment. 54 Accordingly, in the context of parent-subsidiary financing arrangements (such as ScottishPower), this factor often supports equity treatment because the parent/lender owns both the stock and the related-party debt of the subsidiary/borrower. In contrast, in the context of brother-sister financing arrangements (such as Pepsico), there typically is no formal identity of interest between creditor and stockholder (that is, because the common parent, rather than the lender, owns the borrower s stock). Faced with this factual distinction, the IRS had to decide how to proceed. In prior brother-sister financing cases, the IRS has argued that, notwithstanding the absence of a formal identity of interest between creditor and stockholder, the identity of interest factor nevertheless supports equity treatment due to the common control of the borrower and lender. 55 Given the fact that the IRS was arguing for debt treatment in Pepsico, 56 espousing that position would have been counterproductive. However, it seems as though the alternative was not any better. In particular, because the typical debt-equity case finds the IRS arguing for equity treatment in the US, 57 the IRS may have wanted to avoid taking a position in Pepsico 58 that would provide taxpayers with support for the position that a lack of identity of interest between creditor and stockholder in brother-sister financing arrangements supports debt treatment. 59 Stuck between the proverbial rock and a hard place, the IRS came up with a third alternative: assert that the debt-equity factor was simply not relevant to the analysis. 60 Although perhaps the least disagreeable 48 Pepsico, above fn.6, (2012) 104 TCM (CCH) 322, Laidlaw, above fn.46, (1998) 75 TCM (CCH) 2598, Pepsico, above fn.6, (2012) 104 TCM (CCH) 322, Laidlaw, above fn.46, (1998) 75 TCM (CCH) 2598, Pepsico, above fn.6, (2012) 104 TCM (CCH) 322, ScottishPower, above fn.5, (2012) 103 TCM (CCH) 1916, See, e.g. Mixon, above fn.13, (1972) 464 F.2d 394, See IRS Brief, Laidlaw Transportation Inc. v Commissioner (September 5, 1997) No , 79 (TC) Pepsico, above fn.6, (2012) 104 TCM (CCH) 322, 335 fn.48 (observing that In a typical debt-versus-equity case, the Commissioner argues for equity characterization whereas the taxpayers endeavor to secure debt characterization. ) See IRS Internal Revenue Manual, above fn Note that in at least one debt-equity case involving brother-sister financing, the court has found the identity of interest factor to be neutral rather than irrelevant. See Laidlaw, above fn.46, (1998) 75 TCM (CCH) 2598,

9 604 British Tax Review alternative for the IRS in Pepsico, 61 this may be another example of a situation where the IRS s argument while on one side of the debt-equity issue could be used against it when the roles are reversed. In particular, taxpayers will likely point to the IRS argument in Pepsico 62 to rebut any future attempts by the IRS to assert that this debt-equity factor supports equity treatment in the context of brother-sister financing. The court went on to find that both the ninth factor ( thinness of capital structure in relation to debt) and the tenth factor (ability of the corporation to obtain credit from outside sources) supported equity treatment while the eleventh factor (use to which advances were put) supported debt treatment and the twelfth factor (failure of debtor to repay) was neutral. Finally, the court found that the thirteenth factor (risk involved in making advances) also supported equity treatment. After considering each of the 13 debt-equity factors, the court concluded that the advance agreements were properly characterised as equity for US tax purposes. As was the case in ScottishPower, 63 the court observed that [t]he determination of debt or equity is no mere counting of factors. 64 Nevertheless, it is interesting to note that, in the end, the court found seven equity factors, two debt factors, two neutral factors and one factor that was determined to be irrelevant to the analysis. Conclusion Despite taxpayer victories in both ScottishPower 65 and Pepsico, 66 the tables may turn as more and more debt-equity cases work their way through the US court system. Moreover, even just one or two cases upholding an IRS recharacterisation of related-party financing may encourage the IRS to pursue debt-equity cases with increased enthusiasm. With the spectre of more debt-equity controversies looming on the horizon, multinationals should take time now to evaluate the potential vulnerability of their cross-border related-party financing to a debt-equity challenge in the US. Donald L. Korb, * S. Eric Wang ** and James R. Gadwood *** Pepsico, above fn.6, (2012) 104 TCM (CCH) 322, 345 (citing Bauer v Commissioner (1984) 748 F.2d 1365, 1368 (9th Cir)) Debt finance; Equity; Finance; Transfer pricing; United States * Donald L. Korb is a partner in Sullivan & Cromwell LLP s Washington, DC office and is the head of the firm s Tax Controversy Practice. From 2004 to 2008, Mr Korb served as the Chief Counsel for the US Internal Revenue Service. ** S. Eric Wang is a partner in Sullivan & Cromwell LLP s London office. *** James R. Gadwood is an associate in Sullivan & Cromwell LLP s New York office.