INTRODUCTION

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. This determination has led various courts of appeals to identify and consider a multi-factor test for resolving such inquires.

In the typical debt-versus-equity case, the I.R.S. will argue for equity characterization whereas the taxpayer will endeavor to secure debt characterization to obtain an interest deduction. In some cases, the roles are reversed, but this does not require that courts apply different legal principles. Some courts consider 10 factors, while others consider as many as 16 factors. No matter how many factors are considered, the multi-factor test is the established, standard analysis used in such disputes.

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INTRODUCTION

Historically, the I.R.S. and taxpayers often disagreed over whether a loan between related entities should be treated as equity rather than true debt. As a result, substantial case law has built up over the years, especially involving closely-held entities. One such case is Mixon, which was discussed in our prior publication from April 2014 as the leading case law providing for the 13 factors to be considered in debt-equity cases. In recent years, the I.R.S. has begun to focus on the debt-equity issue in the cross border arena, and new decisions are being issued. Two 2012 cases, in the United States Tax Court (the “Tax Court” or “Court”), went in different directions. In PepsiCo, the taxpayer prevailed and equity treatment was upheld. In contrast, the I.R.S. prevailed in Hewlett-Packard, where the Tax Court was convinced that the transaction should be categorized as a loan rather than equity. In this case, the court looked beyond the instrument at issue and also examined agreements between the shareholders in the transaction.

Earlier this year, Hewlett-Packard (“HP”) appealed its loss in the Tax Court to the U.S. Court of Appeals for the Ninth Circuit, arguing that the lower court’s finding – that the investment displayed more “qualitative and quantitative indicia of debt than equity” – was “clearly erroneous.”

HP CASE – FACTS AND TAX COURT DECISION

HP purchased an interest in a Dutch corporation, Foppingadreef (“FOP”), from AIG in 1996. The investment was originally structured by AIG as an equity investment in preferred shares. The other shareholder was a Dutch bank, ABN AMRO (“ABN”). FOP’s Articles of Incorporation provide that it was organized for the purpose of investing its assets in contingent interest notes (“C.I.N.’s”) and other approved debt instruments. FOP invested in C.I.N.’s issued by ABN which provided for interest consisting of a fixed element and a contingent element. The terms of the preferred shares, as structured by AIG, gave HP voting rights and preferred entitlement to dividend distributions. HP’s vote was slightly more than 20%.