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How to deal with debt-equity in the US


The IRS is unhappy with multinationals exploiting cross-border differences in treatment of debt and equity for tax gains and is throwing more resources into preventing it. But Hewlett Packard, Scottish Power and PepsiCo were all challenged in the US Tax Court over debt-equity issues last year and two of them emerged victorious. Joe Dalton explains why such structures are still a valid and beneficial option for taxpayers and how to prepare your case if the IRS comes calling.


The US Tax Court delivered three rulings on debt-equity cases involving multinationals last year

Debt-equity is an issue in 20-30% of all large cases the Internal Revenue Service (IRS) is pursuing and there are almost 300 active cases in the Large Business and International (LB&I) division's inventory.

The majority of these cases involve multinational companies and cross-border transactions.

For US taxpayers, it is quite simply an issue that cannot be ignored.

Tax opportunities arise for multinationals when financing cross-border transactions because the treatment of hybrid debt-equity instruments is not uniform across jurisdictions.

Different countries enforce their own rules for taxing debt and equity and for how each is characterised.

These differences create the opportunity for tax arbitrage, which many multinationals inevitably seek to exploit.

In the US, the IRS has increased the time and resources devoted to pursuing multinationals over debt-equity issues during the last three or four years and it appears to be an issue it will not let go.

"I think the IRS start from a perception that US subsidiaries of multinational corporations have a substantial amount of debt on their balance sheets," says Paul Morton, head of group tax for Reed Elsevier.

This perception tends to be correct for two reasons: one is that growing businesses in the US will finance their activities by debt because that is a sensible way of structuring a balance sheet of a rapidly growing company; and the other is the US's high corporate tax rate of 35%, which means it makes business sense to put in debt rather than equity and claim deductions for the interest.

The US has no statutory definition of debt or equity but rather relies on an all facts and circumstances test. The courts will usually apply an 11 or 13-factor – though this can extend to as many as 15 – analysis to characterise an instrument as debt or equity, in line with this approach.

But the upshot is this can create uncertainty for taxpayers and the IRS.

The US Tax Court has delivered three recent decisions on debt-equity cases: in Hewlett Packard, Scottish Power and PepsiCo.

Though each case is decided by a facts-specific analysis, there are some important takeaways for taxpayers. And there are also valuable lessons to be learnt from these taxpayers' experiences about how you can put a debt-equity case together if you are unfortunate enough to receive an IRS challenge in your mailbox next Monday morning.

Scottish Power

The Tax Court found in favour of Scottish Power in June.

The UK-based energy multinational was challenged in relation to its financing arrangements for the acquisition of US utility company PacifiCorp.

In 1999, Scottish Power agreed to acquire 100% of PacifiCorp's stock, which it did using a US subsidiary called NA General Partnership & Subsidiaries (NAGP) as the acquisition vehicle.

The merger agreement provided that NAGP would own PacifiCorp's shares and would issue loan notes to Scottish Power in consideration for those shares. NAGP also pledged its PacifiCorp shares as security for repayment of the loan.

Between 2000 and 2002, though NAGP did not always make interest payments on time, it did eventually pay all of the interest owed on the notes.

NAGP used PacifiCorp dividends to make a large proportion of the interest payments to Scottish Power.

The IRS claimed Scottish Power's advance of its stock to NAGP in connection with the PacifiCorp acquisition was a capital contribution, characterised as equity, and therefore the repayments were taxable dividends.

Scottish Power argued the advance was a loan and the payments were deductible as interest.

The court, through an 11-factor analysis, ruled that the transaction should be treated as debt.

Miriam Fisher, who is now at Latham & Watkins, but tried the Scottish Power case while at Morgan & Lewis, believes some of the debt-equity analysis factors used by the courts hold more sway than others.

"Probably the two most important factors are reasonable expectation of repayment and intent of the parties," says Fisher.

"With cash-flow projections, you must show that both the principal and the interest are reasonably anticipated to be repaid and there needs to be a record showing that was considered in advance; that you have some idea of what the source of repayment will be and what the timing on that will be is critical.

"Intent of the parties will be demonstrated in many ways such as the form of the transaction, what the papers look like and the actions of the parties both before and after the instruments are put in place," adds Fisher.


A second taxpayer victory arrived in September, when the Tax Court ruled in favour of PepsiCo.

In the mid-1990s, PepsiCo restructured its international operations so its overseas investments – mainly into the Eastern European and Asian markets – could be made by Netherlands holding companies and funded through advance agreements between the Dutch units and certain PepsiCo subsidiaries and PepsiCo Puerto Rico.

The advance agreements – which the Dutch tax authorities ruled were debt instruments – were issued by a Dutch unit that was indirectly wholly owned by PepsiCo. They were issued to several PepsiCo domestic subsidiaries in exchange for notes (the Frito-Lay notes) issued by PepsiCo.

PepsiCo intended the advance agreements to be treated as equity for US tax purposes and as debt for Dutch tax purposes.

The IRS contended that the advance agreements were debt instruments and should be treated as such for US tax purposes.

The court states that though a singular defined set of standards capable of being uniformly applied in debt-versus-equity inquiries remains elusive, the focus of a debt-versus-equity inquiry generally narrows to whether there was intent to create a debt with a reasonable expectation of repayment and, if so, whether that intent comports with the economic reality of creating a debtor-creditor relationship.

Douglas Stransky, of Sullivan & Worcester, agrees with Fisher, saying if he had to find a 'super' factor in debt-equity analyses it would be the degree of certainty regarding the obligation to repay.

"In PepsiCo, the court found that, like equity, there was no expectation of repayment because there was uncertainty as to whether the amounts advanced could be repaid," says Stransky.

"Similarly, use of an advance by an ongoing business to expand its operations indicates that an advance is equity, whereas an advance utilised to provide working capital for the day-to-day operations of a business indicates debt."

"It is easier to make the argument that an advance is equity if the one receiving the advance used the funds to obtain a valuable asset that is expected to increase in value over time to expand the business," Stransky adds.

Hewlett Packard

Hewlett Packard did not fare so well, losing its Tax Court case in May.

The IT multinational became involved in a scheme constructed by American International Group-Financial Products (AIG-FP) during the 1990s whereby derivatives were traded to generate capital losses and foreign tax credits which could be used by companies to lower their US tax liability.

Hewlett Packard attempted to use its investments in Foppingadreef, a newly formed entity created by AIG-FP and Dutch bank ABN, as capital loss deductions in the US.

The court said the investments in Foppingadreef were not valid for capital-loss deductions because they were not real economic bets but carefully structured loans made by Hewlett Packard to Foppingadreef which were paid back.

"Hewlett Packard's investment is more appropriately characterised as debt, rather than equity, for federal income tax purposes and the taxpayer is not entitled to deduct a capital loss for the sale of its interest in Foppingadreef," the ruling states.

Hewlett Packard's inability to demonstrate that there was real economic risk in the investments proved decisive.

Implementing a hybrid instrument

Though Hewlett Packard lost its Tax Court case, the court's judgments in Scottish Power and PepsiCo show that the intent to undertake meticulous tax planning in this area will not necessarily weigh against taxpayers.

Multinationals will therefore be encouraged to persevere with such planning.

And using lessons from other taxpayers' experiences will put them on firmer ground when they do this.

Fisher says part of the IRS's strategy in Scottish Power was to try and superimpose an unrelated third party structure over a related party structure and say they must be identical.

"There was a lot of focus by the IRS, certainly in cases I was involved in, on this hypothetical third party lender analysis, so I think if you are planning a transaction today and you can go out and talk to a third party lender, ask what terms you would get from them and how well they know your business, then have that documented, it would be wonderful to have evidence in the file showing what a hypothetical lender would have done," says Fisher.

"If I was starting from scratch, that is what I would do," she adds.

As in other areas of US tax law, it is of course an advantage if the arrangement is associated with a significant business acquisition or reorganisation.

And though certain analysis factors may ultimately hold more sway, an ability to support each of the potential 11-15 factors that may be relied upon by the courts is important.

In PepsiCo, the Tax Court identified 13 factors for characterising an instrument as debt or equity:

  • Names or labels given to the instruments;

  • Presence or absence of a fixed maturity date;

  • Source of payments;

  • Right to enforce payments;

  • Participation in management as a result of the advances;

  • Status of the advances in relation to regular corporate creditors;

  • Intent of the parties;

  • Identity of interest between creditor and stockholder;

  • "Thinness" of capital structure in relation to debt;

  • Ability of the corporation to obtain credit from outside sources;

  • Use to which advances were put;

  • Failure of debtor to repay; and

  • Risk involved in making advances.

Taxpayers must also be careful when being advised on financing arrangements because it is such a specialist area. Generally, tax professionals do not have the background knowledge to undertake a credit analysis in the way that a bank or credit rating agency would do.

"This is a very technical area, especially in terms of how the financial world assesses creditability and appropriate levels of leverage," says Morton.

"What is very interesting is that treasury people, credit experts, rating agencies and banks speak a very different language and have a completely different frame of reference from tax people and lawyers and there is a bigger gulf to cross there than I think is probably apparent to many people," he adds.

Putting a case together

If a taxpayer is challenged on a debt-equity issue, it is important to bear in mind that under any circumstances it will be a heavily factual case.

Donald Korb, of Sullivan & Cromwell, says it is important to begin with the end in mind, by selecting a law firm with the ability to take the case all the way through the process.

This is something that Pinsent Masons tax specialist Heather Self, Scottish Power's director of group taxation while it was facing challenge in the US, agrees with.


Heather Self: Dealing with the IRS can be challenging

"It is important to understand what you want to achieve from the outset and make sure you have advisers who could potentially take the case all the way through to litigation, if there is a possibility it could go that far," says Self.

"From the perspective of a UK taxpayer, I also needed someone who was on my wavelength and able to communicate to me as a non-US person anything I was having difficulty with regarding how the US process worked and how the IRS operated. It is vital that you know your enemy in a dispute such as this," she adds.

An accounting firm will also be required for computational matters, reconciling tax returns to underlying books and records and building financial models.

Given the factual nature of debt-equity cases, building a strong body of evidence to support the facts through documentation, witnesses and experts is imperative.

Developing a solid outline of a statement of facts as early as possible will help guide responses to information document requests (IDR), the notice of proposed adjustment and in preparing the protest.

The factual areas to consider covering in the statement of facts are closely aligned to the 11-13 points of analysis likely to be investigated by a court.

Korb says the next big consideration is how to tell your story and to develop a theme for your case.

This involves showing the business reasons for increases in debt levels; showing why additional debt made sense from the perspective of the capital structure of the borrower; demonstrating sufficient cashflow was generated to repay the interest and at least part of the principal; showing the projected payback period is reasonable; showing that the borrower could have borrowed from a third party lender on substantially similar terms and showing an acceptable financial ratio for the borrower.

The degree of evidence required to support your position will obviously increase as the case moves along. Expert witnesses should be brought in once the case gets to the appeals stage, though further testimonies may be required if the case goes to litigation.

Where a dispute reaches litigation there will be a whole army of people involved.

Finding the right witnesses and deciding which angles to cover is undertaken with the legal advisers and experts will often be engaged via specialist expert consulting firms.

In Scottish Power, the IRS focused heavily on a hypothetical third party lender analysis, so the company employed experts to address this.

"We had an expert in the energy sector of debt capital markets because had Scottish Power gone out into the market to finance this acquisition with debt, rather than doing it internally, we argued they would have done it through a debt capital markets transaction," says Fisher.

"We knew our IRS team was obsessed with third party lending so we had someone from the energy sector who said this would have made a very attractive offering and here's how we would have divided up the debt," she adds.

Another consideration is at what stage to tell the full story of the case.

Morton says it is a matter of quite delicate judgment when you lay the full story out.

"If the examining team are engaging in a meaningful discussion of the issues and you feel it is going to be possible to influence or even inform them in a helpful way, it might be very useful to set out the arguments in detail very early on," says Morton.

"On the other hand, if they have formed their own views, perhaps based on real misunderstandings of the facts or the background of commercial practices and they are not going to be moved then to some extent there is no point spending a lot of time, energy and cost in setting out arguments which aren't going to be listened to or understood," he adds.

It is also useful to be aware of common problems likely to be encountered when facing the IRS on a debt-equity challenge.

The first point to make is that removing penalties from the negotiating table is always a priority, but the examiner may be reluctant to allow this before the full story is aired.

Secondly, Self says the IRS follows a much more substantive tick and check approach than HM Revenue & Customs for example, so be prepared for many factual questions and a lot of document requests.

And both advisers and taxpayers warn that some operational level IRS staff may lack substantive tax experience to cope with debt-equity issues.

"It is probably fair to say the IRS is finding it a bit of a challenge understanding the issues in this area and framing arguments appropriately," says Morton.

"One example is the permanent and enduring role played by debt in a properly structured balance sheet. Financing of a large corporate is very different from consumer finance where over time consumers will be expected to reduce their indebtedness," he adds.

The courts have shown that legitimate tax planning involving hybrid financing arrangements can succeed, while the IRS is clearly unsettled by the concept and continues to target multinationals over debt-equity.

With that in mind, taxpayers should tread carefully from the outset when employing debt-equity arrangements, learn the lessons from the recent Tax Court cases, adopt a strong position from the outset and consider building a body of evidence to support that position as they go along.

Read more about how to put a debt-equity case together here

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