Us Debt Equity Special Feb2013

7/30/2019 Us Debt Equity Special Feb2013

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Joe Dalton

The IRS is unhappy with multinationals

exploiting cross-border differences in

treatment of debt and equity for taxgains 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 IRScomes calling.

D ebt-equity is an issue in 20-30% of all largecases the Internal Revenue Service (IRS) ispursuing and there are almost 300 active cases

in the Large Business and International (LB&I)divisions inventory.

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

For US taxpayers, it is quite simply an issue

that cannot be ignored.

Tax opportunities arise for multinationalswhen financ ing cross -border transactionsbecause 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 ischaracterised.

These differences create the opportunity for

tax arbitrage, which many multinationalsinevitably seek to exploit.

In the US, the IRS has increased the time andresources devoted to pursuing multinationals over

debt-equity issues during the last three or fouryears 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 havea substantial amount of debt on their balance

sheets, says Paul Morton, head of group tax forReed Elsevier.

This perception tends to be correct for tworeasons: one is that growing businesses in the USwill finance their activities by debt because that is

a sensible way of structuring a balance sheet of arapidly growing company; and the other is theUSs high corporate tax rate of 35%, which meansit 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 circum-stances test. The courts will usually apply an 11 or13-factor though this can extend to as many as

15 analysis to characterise an instrument as debtor equity, in line with this approach.

But the upshot is this can create uncertainty fortaxpayers and the IRS.

The US Tax Court has delivered three recent

decisions on debt-equity cases: in Hewlett-Packard, Scottish Powerand PepsiCo.

Though each case is decided by a facts-specif-

ic analysis, there are some important takeaways

for taxpayers. And there are also valuable lessonsto be learnt from these taxpayers experiencesabout how you can put a debt-equity casetogether if you are unfortunate enough to

receive an IRS challenge in your mailbox nextMonday morning.

Scottish Power

The Tax Court found in favour of Scottish

Power in June.

The UK-based energy multinational waschallenged in relation to its financing arrange-

ments for the acquisition of US utility companyPacifiCorp.

In 1999, Scottish Power agreed to acquire100% of PacifiCorps stock, which it did using aUS subsidiary called NA General Partnership &Subsidiaries (NAGP) as the acquisition vehicle.

The merger agreement provided that NAGPwould own PacifiCorps shares and would issueloan notes to Scottish Power in considerationfor those shares. NAGP also pledged itsPacifiCorp shares as security for repayment of

the loan.

Between 2000 and 2002, though NAGP didnot always make interest payments on time, itdid eventually pay all of the interest owed on the

notes.NAGP used PacifiCorp dividends to make a

large proportion of the interest payments toScottish Power.

The IRS claimed Scottish Powers advance of

its stock to NAGP in connection with thePacifiCorp acquisition was a capital contribu-

tion, characterised as equity, and therefore the

repayments were taxable dividends.

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

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

Miriam Fisher, who is now at Latham &

Watkins, but tried the Scottish Power case whileat Morgan & Lewis, believes some of the debt-equity analysis factors used by the courts holdmore sway than others.

Probably the two most important factorsare reasonable expectation of repayment and

intent of the parties, says Fisher.With cash-flow projections, you must showthat both the principal and the interest are rea-

sonably anticipated to be repaid and there needsto be a record showing that was considered inadvance; that you have some idea of what thesource of repayment will be and what the timingon that will be is critical.

Intent of the parties will be demonstrated inmany ways such as the form of the transaction,

Contents Next pagePrevious pagewww.internationaltaxreview.comPage 2

US DEBT-EQUITY

How to deal with debt-equity in the US

The US Tax Court delivered three rulings on debt-equity cases involving multinationals last year
http://www.internationaltaxreview.com/Article/3147880/US-ITR-Premium-Archive/IRS-refreshes-membership-of-advisory-and-information-reporting-councils.htmlhttp://www.internationaltaxreview.com/Article/2951560/Search/Asia-directors-unveil-long-list-of-concerns.htmlhttp://www.internationaltaxreview.com/Article/2951560/Search/Asia-directors-unveil-long-list-of-concerns.htmlhttp://www.internationaltaxreview.com/Article/3130939/Search/Top-five-tax-rulings-for-multinationals-in-2012.htmlhttp://www.internationaltaxreview.com/Article/3147873/US-ITR-Premium-Archive/US-taxpayers-reject-limiting-corporate-interest-deductions-to-fund-rate-cut.htmlhttp://www.internationaltaxreview.com/http://www.internationaltaxreview.com/Article/3147880/US-ITR-Premium-Archive/IRS-refreshes-membership-of-advisory-and-information-reporting-councils.htmlhttp://www.internationaltaxreview.com/Article/2951560/Search/Asia-directors-unveil-long-list-of-concerns.htmlhttp://www.internationaltaxreview.com/Article/2951560/Search/Asia-directors-unveil-long-list-of-concerns.htmlhttp://www.internationaltaxreview.com/Article/3130939/Search/Top-five-tax-rulings-for-multinationals-in-2012.htmlhttp://www.internationaltaxreview.com/Article/3147873/US-ITR-Premium-Archive/US-taxpayers-reject-limiting-corporate-interest-deductions-to-fund-rate-cut.htmlhttp://www.internationaltaxreview.com/


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what the papers look like and the actions of theparties both before and after the instruments areput in place, adds Fisher.

PepsiCo

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 invest-

ments mainly into the Eastern European andAsian markets could be made by Netherlandsholding companies and funded throughadvance agreements between the Dutch units

and certain PepsiCo subsidiaries and PepsiCoPuerto Rico.

The advance agreements which the Dutchtax authorities ruled were debt instruments were issued by a Dutch unit that was indirectly

wholly owned by PepsiCo. They were issued toseveral PepsiCo domestic subsidiaries inexchange for notes (the Frito-Lay notes) issuedby PepsiCo.

PepsiCo intended the advance agreements tobe treated as equity for US tax purposes and as

debt for Dutch tax purposes.The IRS contended that the advance agree-

ments were debt instruments and should betreated as such for US tax purposes.

The court states that though a singular

defined set of standards capable of being uni-

formly applied in debt-versus-equity inquiriesremains elusive, the focus of a debt-versus-equi-ty inquiry generally narrows to whether there

was intent to create a debt with a reasonableexpectation of repayment and, if so, whetherthat intent comports with the economic realityof creating a debtor-creditor relationship.

Douglas Stransky, of Sullivan & Worcester,

agrees with Fisher, saying if he had to find asuper factor in debt-equity analyses it would be

the degree of certainty regarding the obligationto repay.

In PepsiCo, the court found that, like equity,there was no expectation of repayment becausethere 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 thatan advance is equity, whereas an advance utilisedto provide working capital for the day-to-dayoperations of a business indicates debt.

It is easier to make the argument that an

advance is equity if the one receiving theadvance used the funds to obtain a valuableasset that is expected to increase in value overtime to expand the business, Stransky adds.

Hewlett-Packard

Hewlett-Packard did not fare so well, losing itsTax Court case in May.

The IT multinational became involved in ascheme constructed by American InternationalGroup-Financial Products (AIG-FP) during the1990s whereby derivatives were traded to gen-

erate capital losses and foreign tax credits whichcould be used by companies to lower their UStax liability.

Hewlett-Packard attempted to use its invest-

ments in Foppingadreef, a newly formed entitycreated by AIG-FP and Dutch bank ABN, as

capital loss deductions in the US.The court said the investments inFoppingadreef were not valid for capital-loss

deductions because they were not real econom-ic bets but carefully structured loans made byHewlett-Packard to Foppingadreef which werepaid back.

Hewlett-Packards investment is more

appropriately characterised as debt, rather thanequity, for federal income tax purposes and the

taxpayer is not entitled to deduct a capital lossfor the sale of its interest in Foppingadreef, the

ruling states.Hewlett-Packards inability to demonstrate

that there was real economic risk in the invest-

ments proved decisive.

Implementing a hybrid instrument

Though Hewlett-Packard lost its Tax Court

case, the courts judgments in Scottish PowerandPepsiCo show that the intent to undertakemeticulous tax planning in this area will notnecessarily 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 groundwhen they do this.

Fisher says part of the IRSs strategy inScottish Powerwas to try and superimpose anunrelated third party structure over a relatedparty structure and say they must be identical.

There was a lot of focus by the IRS, certain-ly in cases I was involved in, on this hypotheti-

cal third party lender analysis, so I think if youare planning a transaction today and you can goout and talk to a third party lender, ask whatterms you would get from them and how wellthey know your business, then have that docu-

mented, it would be wonderful to have evidence

in the file showing what a hypothetical lenderwould have done, says Fisher.If I was starting from scratch, that is what I

would do, she adds.

As inother areas of US tax law, it is of coursean advantage if the arrangement is associatedwith a significant business acquisition or reor-ganisation.

And though certain analysis factors may ulti-

mately hold more sway, an ability to support

each of the potential 11-15 factors that may berelied upon by the courts is important.

In PepsiCo, the Tax Court identified 13 fac-

tors for characterising an instrument as debt orequity:

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 creditfrom 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 onfinancing arrangements because it issuch a specialist area. Generally, tax profession-als do not have the background knowledge toundertake a credit analysis in the way that abank or credit rating agency would do.

This is a very technical area, especially in

terms of how the financial world assesses cred-itability and appropriate levels of leverage, saysMorton.

What is very interesting is that treasury peo-

ple, credit experts, rating agencies and banksspeak a very different language and have a com-pletely different frame of reference from taxpeople and lawyers and there is a bigger gulf tocross there than I think is probably apparent to

many people, he adds.


US DEBT-EQUITY
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Putting a case together

If a taxpayer is challenged on a debt-equityissue, it is important to bear in mind that underany circumstances it will be a heavily factual

case.

Donald Korb, of Sullivan & Cromwell, says itis important to begin with the end in mind, byselecting 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 Powers directorof group taxation while it was facing challengein the US, agrees with.

It is important to understand what youwant to achieve from the outset and make sureyou have advisers who could potentially take thecase all the way through to litigation, if there isa possibility it could go that far, says Self.

From the perspective of a UK taxpayer, Ialso needed someone who was on my wave-length and able to communicate to me as a non-US person anything I was having difficulty with

regarding how the US process worked and howthe 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 returnsto underlying books and records and buildingfinancial models.

Given the factual nature of debt-equity cases,

building a strong body of evidence to supportthe facts through documentation, witnesses andexperts is imperative.

Developing a solid outline of a statement offacts as early as possible will help guide respons-es to information document requests (IDR), thenotice of proposed adjustment and in preparingthe protest.

The factual areas to consider covering in thestatement of facts are closely aligned to the 11-

13 points of analysis likely to be investigated bya court.

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

This involves showing the business reasonsfor increases in debt levels; showing why addi-

tional debt made sense from the perspective ofthe capital structure of the borrower; demon-strating sufficient cashflow was generated torepay the interest and at least part of the princi-pal; showing the projected payback period is

reasonable; showing that the borrower couldhave borrowed from a third party lender onsubstantially similar terms and showing anacceptable financial ratio for the borrower.

The degree of evidence required to supportyour position will obviously increase as the case

moves along. Expert witnesses should bebrought in once the case gets to the appealsstage, 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 decidingwhich angles to cover is undertaken with thelegal advisers and experts will often be engagedvia 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 ofdebt capital markets because had Scottish Power

gone out into the market to finance this acqui-sition with debt, rather than doing it internally,we argued they would have done it through adebt capital markets transaction, says Fisher.

We knew our IRS team was obsessed with

third party lending so we had someone from theenergy sector who said this would have made a

very attractive offering and heres how wewould have divided up the debt, she adds.

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

Morton says it is a matter of quite deli-

cate judgment when you lay the full storyout.

If the examining team are engaging ina meaningful discussion of the issues andyou feel it is going to be possible to influ-ence or even inform them in a helpful way,it might be very useful to set out the argu-

ments in detail very early on, says Morton.On the other hand, if they have formed

their own views, perhaps based on real mis-understandings of the facts or the back-

ground of commercial practices and theyare not going to be moved then to some

extent there is no point spending a lot oftime, energy and cost in setting out argumentswhich arent going to be listened to or under-

stood, he adds.It is also useful to be aware of common prob-

lems likely to be encountered when facing theIRS on a debt-equity challenge.

The first point to make is that removing

penalties from the negotiating table is always apriority, but the examiner may be reluctant toallow this before the full story is aired.

Secondly, Self says the IRS follows a much

more substantive tick and check approach thanHM Revenue & Customs for example, so beprepared for many factual questions and a lot ofdocument requests.

And both advisers and taxpayers warn that

some operational level IRS staff may lack sub-stantive tax experience to cope with debt-equityissues.

It is probably fair to say the IRS is finding ita bit of a challenge understanding the issues in

this area and framing arguments appropriately,says Morton.

One example is the permanent and endur-ing role played by debt in a properly structuredbalance sheet. Financing of a large corporate is

very different from consumer finance whereover time consumers will be expected to reducetheir indebtedness, he adds.

The courts have shown that legitimate taxplanning involving hybrid financing arrange-

ments can succeed, while the IRS is clearly

unsettled by the concept and continues to targetmultinationals over debt-equity.With that in mind, taxpayers should tread care-

fully from the outset when employing debt-equi-

ty arrangements, learn the lessons from the recentTax Court cases, adopt a strong position from theoutset and consider building a body of evidenceto support that position as they go along.Read more about how to put a debt-equity case

togetherhere


US DEBT-EQUITY

Heather Self: Dealing with the IRS can be challenging
http://www.internationaltaxreview.com/Article/3056407/Tax-Disputes-Archive/Former-IRS-chief-counsel-tells-taxpayers-what-to-expect-in-tax-litigation.htmlhttp://www.internationaltaxreview.com/Article/3078912/Tax-Disputes-Archive/Taxpayers-guide-to-UK-disputes-and-HMRCs-litigation-strategy.htmlhttp://www.internationaltaxreview.com/Article/3150215/Search/PAC-hearing-shows-gulf-between-Big-4-and-public-opinion.htmlhttp://www.internationaltaxreview.com/Article/3150215/Search/PAC-hearing-shows-gulf-between-Big-4-and-public-opinion.htmlhttp://www.internationaltaxreview.com/pdfs/Putting-a-debt-equity-case-together.PPThttp://www.internationaltaxreview.com/pdfs/Putting-a-debt-equity-case-together.PPThttp://www.internationaltaxreview.com/http://www.internationaltaxreview.com/Article/3056407/Tax-Disputes-Archive/Former-IRS-chief-counsel-tells-taxpayers-what-to-expect-in-tax-litigation.htmlhttp://www.internationaltaxreview.com/Article/3078912/Tax-Disputes-Archive/Taxpayers-guide-to-UK-disputes-and-HMRCs-litigation-strategy.htmlhttp://www.internationaltaxreview.com/Article/3150215/Search/PAC-hearing-shows-gulf-between-Big-4-and-public-opinion.htmlhttp://www.internationaltaxreview.com/Article/3150215/Search/PAC-hearing-shows-gulf-between-Big-4-and-public-opinion.htmlhttp://www.internationaltaxreview.com/pdfs/Putting-a-debt-equity-case-together.PPThttp://www.internationaltaxreview.com/


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Joe Dalton

The US Tax Courts 100-page judgment

in the debt-versus-equity litigation

concerning soft drinks company PepsiCocould help indicate the super factor in

characterising a structure.

The US Tax Court ruled that the advanceagreements PepsiCo set up are appropri-ately characterised as equity for the purposesof US federal income tax.

PepsiCo and PepsiCo Puerto Rico

The Internal Revenue Service (IRS) deter-mined total tax deficiencies for PepsiCo and

PepsiCo Puerto Rico (PPR) of around $363million for years between 1998 and 2002.

In the mid-1990s, PepsiCo sought to takeadvantage of business opportunities in EasternEurope and Asia.

It was apparent that billions of dollars in

capital investments would be required toestablish its brands in these markets.

For reasons allegedly motivated by businesspurpose and tax, PepsiCo reorganised its

international holdings to allow for a moreeffective use of overseas earnings and to avoidmoving cash directly from the US to fund itsoverseas expansion which would have createdwithholding tax liab ilities in the US.

The multinational restructured its interna-tional operations so its overseas investmentscould be made by Netherlands holding com-panies and funded through advance agree-ments transactions carried out under

pre-arranged conditions between the Dutchunits and certain PepsiCo subsidiaries and PPR,

wh i ch

the Dutch

tax authoritiesruled were debt instruments.

PepsiCo anticipated that the IRS, wouldtreat payments from its Dutch subsidiaries to its

US parent, pursuant to the advance agreementsas distributions on equity.

With earnings and profits of the Dutch com-panies predicted to be drastically reduced or elim-

inated by losses on their investments in theforeseeable future, PepsiCo thought it likely thatit would not be taxed in the US on repatriatedincome or dividend treatment on distributions.

The Tax Court was asked to consider twoissues: whether advance agreements issued by

PepsiCos Netherlands subsidiaries to certain

PepsiCo domestic subsidiaries and PPR aremore appropriately characterised as debt thanas equity; and

if the advance agreements are characterised asdebt, whether, and to what extent payments

on the advance agreements constitute origi-

nal issue discount, relating to contingentpayment debt instruments under section1.1275-4(c) of the Internal Revenue Code.

Tax Court rulingThe court noted that a singular defined set ofstandards capable of being uniformly applied indebt-versus-equity inquiries remains elusive.However, the judgment added: the focus of adebt-versus-equity inquiry generally narrows to

whether there was an intent to create a debtwith a reasonable expectation of repayment and,if so, whether that intent comports with theeconomic reality of creating a debtor-creditor

relationship.It identified 13 factors to consider in charac-

terising the 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 andstockholder;

thinness of capital structure in relation to

debt;

ability of the corporation to obtain creditfrom outside sources;

use to which advances were put; failure of debtor to repay; and

risk involved in making advances.The court said that several factors established

the uncertainty of repayment of principal ontheadvance agreements, which therefore led it tocharacterise the transaction as equity.

In particular, the long and conditionalmaturity dates of the advance agreements,

considered in the light of PGIs (Dutch sub-sidiary) investments in foreign markets, sub-ject repayment to the success of suchventures, sa id the cour t.

The overall subordination of the payments,

the lack of legitimate creditor remedies toensure repayment of principal and the indica-tion of the independent creditor test that a com-mercial bank or third-party lender would not

have engaged in transactions of comparable riskwere also cited by the cour t.


US DEBT-EQUITY

Does Pepsis Tax Court win reveal super factor in debt-equity cases?
http://www.ustaxcourt.gov/InOpHistoric/PepsicoMemo.TCM.WPD.pdfhttp://www.internationaltaxreview.com/Article/3049830/US-ITR-Premium-Archive/How-Scottish-Powers-US-Tax-Court-victory-could-hamper-IRS.htmlhttp://www.internationaltaxreview.com/Article/3120679/Search/Advance-rulingsa-giant-step-for-China.htmlhttp://www.internationaltaxreview.com/Article/3120679/Search/Advance-rulingsa-giant-step-for-China.htmlhttp://www.internationaltaxreview.com/Article/3120679/Search/Advance-rulingsa-giant-step-for-China.htmlhttp://www.internationaltaxreview.com/Article/3120679/Search/Advance-rulingsa-giant-step-for-China.htmlhttp://www.internationaltaxreview.com/http://www.ustaxcourt.gov/InOpHistoric/PepsicoMemo.TCM.WPD.pdfhttp://www.internationaltaxreview.com/Article/3049830/US-ITR-Premium-Archive/How-Scottish-Powers-US-Tax-Court-victory-could-hamper-IRS.htmlhttp://www.internationaltaxreview.com/Article/3120679/Search/Advance-rulingsa-giant-step-for-China.htmlhttp://www.internationaltaxreview.com/Article/3120679/Search/Advance-rulingsa-giant-step-for-China.htmlhttp://www.internationaltaxreview.com/


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Implications

Douglas Stransky, of Sullivan &Worcester, said debt-versus-equitycases are always based on a facts

and circumstances analysis and

while each case is different in itsoverall facts, some of the analysisfactors involved may exert a greaterinfluence on the decision.

Although courts generally donot articulate it, I think if we had tofind a super factor, we would saythat this super factor is whetherthere is a mechanism for immediate

repayment upon default, i.e thedegree of certainty regarding theobligation to repay, said Stransky.

In this case, the court found

that, like equity, there was noexpectation of repayment becausethere was uncertainty as to whetherthe amounts advanced could berepaid, he added.

It is also interesting to note thecourts assertion that where a company uses anadvance of funds to acquire capital assets, theadvance is more likely to be characterised asequity.

Similarly, use of an advance by an ongoingbusiness to expand its operations indicates thatan advance is equity, whereas an advanceutilised to provide working capital for the day-

to-day operations of a business indicates debt,said Stransky.

In other words, it is easier to make the argu-ment that an advance is equity if the one receiv-ing the advance used the funds to obtain a

valuable asset that is expected to increase invalue over time in order to expand the busi-ness, he added.

The PepsiCo case is the latest in a string ofdecisions from the US Tax Court and Court of

Appeals which have dealt with the debt-versus-equity issue.

Similar to previous cases, PepsiCo shows that ifa taxpayer carefully considers the factors outlinedin the circuit in which it does business, it is likely

to be successful in its characterisation of anadvance as debt or equity.

But Donald Korb, of Sullivan & Cromwell,said the most similar case to PepsiCo is Hewlett-Packard, but it is difficult to reconcile the analysisused in the two judgments, even though theywere both issued by judge Goeke.

As a case tackling hybrid instruments, I think

you have to look at how PepsiCo matches up with

the Hewlett-Packard decision which the IRS wontaking the position that the instrument was equi-ty and not debt, and I dont think PepsiCo doesthat very well, he said.

I think therefore that

these two cases have mud-died the water in this areaand so the IRS will go backand continue to put these

types of challenges togethereven though it has lost inPepsiCo, he added.

Kerry Snow, a PepsiCospokesperson, said the com-

pany is pleased with thecourts decision in the case.

Mario Verdolini, Scott Wise and LeslieAltus of Davis Polk & Wardwell representedthe taxpayer.


US DEBT-EQUITY

Further reading on

US Court of Appeals ruling sheds light on debt vs equity

Former IRS chief counsel tells taxpayers what to expect in taxlitigation

IRS likely to increase debt vs equity analysis after harsh GeneralElectric ruling

www.ITRPremium.com

Donald Korb says PepsiCoand Hewlett-Packardhave muddied the water in debt-equity cases
http://www.internationaltaxreview.com/Article/2973423/US-ITR-Premium-Archive/IRS-likely-to-increase-debt-vs-equity-analysis-after-harsh-General-Electric-ruling.htmlhttp://www.internationaltaxreview.com/Article/2973423/US-ITR-Premium-Archive/IRS-likely-to-increase-debt-vs-equity-analysis-after-harsh-General-Electric-ruling.htmlhttp://www.internationaltaxreview.com/Article/3031764/US-ITR-Premium-Archive/Hewlett-Packards-court-defeat-is-bad-news-for-US-banks.htmlhttp://www.internationaltaxreview.com/Article/3031764/US-ITR-Premium-Archive/Hewlett-Packards-court-defeat-is-bad-news-for-US-banks.htmlhttp://www.internationaltaxreview.com/http://www.internationaltaxreview.com/Article/3079434/Tax-Disputes-Archive/US-Court-of-Appeals-ruling-sheds-light-on-debt-vs-equity.htmlhttp://www.internationaltaxreview.com/Article/3056407/Tax-Disputes-Archive/Former-IRS-chief-counsel-tells-taxpayers-what-to-expect-in-tax-litigation.htmlhttp://www.internationaltaxreview.com/Article/3056407/Tax-Disputes-Archive/Former-IRS-chief-counsel-tells-taxpayers-what-to-expect-in-tax-litigation.htmlhttp://www.internationaltaxreview.com/Article/2973423/US-ITR-Premium-Archive/IRS-likely-to-increase-debt-vs-equity-analysis-after-harsh-General-Electric-ruling.htmlhttp://www.internationaltaxreview.com/Article/2973423/US-ITR-Premium-Archive/IRS-likely-to-increase-debt-vs-equity-analysis-after-harsh-General-Electric-ruling.htmlhttp://www.internationaltaxreview.com/Article/2973423/US-ITR-Premium-Archive/IRS-likely-to-increase-debt-vs-equity-analysis-after-harsh-General-Electric-ruling.htmlhttp://www.internationaltaxreview.com/Article/2973423/US-ITR-Premium-Archive/IRS-likely-to-increase-debt-vs-equity-analysis-after-harsh-General-Electric-ruling.htmlhttp://www.internationaltaxreview.com/Article/3031764/US-ITR-Premium-Archive/Hewlett-Packards-court-defeat-is-bad-news-for-US-banks.htmlhttp://www.internationaltaxreview.com/Article/3031764/US-ITR-Premium-Archive/Hewlett-Packards-court-defeat-is-bad-news-for-US-banks.htmlhttp://www.internationaltaxreview.com/http://www.internationaltaxreview.com/Article/3079434/Tax-Disputes-Archive/US-Court-of-Appeals-ruling-sheds-light-on-debt-vs-equity.htmlhttp://www.internationaltaxreview.com/Article/3056407/Tax-Disputes-Archive/Former-IRS-chief-counsel-tells-taxpayers-what-to-expect-in-tax-litigation.htmlhttp://www.internationaltaxreview.com/Article/3056407/Tax-Disputes-Archive/Former-IRS-chief-counsel-tells-taxpayers-what-to-expect-in-tax-litigation.htmlhttp://www.internationaltaxreview.com/Article/2973423/US-ITR-Premium-Archive/IRS-likely-to-increase-debt-vs-equity-analysis-after-harsh-General-Electric-ruling.htmlhttp://www.internationaltaxreview.com/Article/2973423/US-ITR-Premium-Archive/IRS-likely-to-increase-debt-vs-equity-analysis-after-harsh-General-Electric-ruling.html


7/9

Joe Dalton

The IRS may need to reconsider its

position when challenging certain debt

instruments after Scottish Power won itsUS Tax Court case over the tax

deductibility of interest.

The courts opinion said a transaction under-taken by Scottish Power to finance theacquisition of US utility company PacifiCorp,and interest subsequently received by Scottish

Power, should be characterised as debt ratherthan equity, and the company was thereforeentitled to tax deductions on $932 million ofinterest payments.

Background

In 1999, Scottish Power, a UK company, agreedto acquire 100% of PacifiCorps issued and com-mon stock.

Scottish Power structured the transaction so it

was an indirect acquisition, using a US companyit owned NA General Partnership &Subsidiaries (NAGP) as the acquisition vehicle.

The merger agreement provided that NAGPwould own PacifiCorps shares and would issue

loan notes to Scottish Power in consideration forthose shares. NAGP also pledged its PacifiCorpshares as security for repayment of the loan.

The loan notes issued by NAGP to Scottish

Power consisted of $4 billion of fixed-rate loannotes and $896 million of floating-rate notes.

Scottish Power and NAGP both treated theloan notes as debt.

Between 2000 and 2002, although NAGP

did not always make interest payments on time,it did eventually pay all of the interest owed onthe notes.

NAGP used PacifiCorp dividends to make a

large proportion of the interest payments toScottish Power.

In 2002, PwC advised Scottish Power to cap-italise the debt.

Scottish Power subsequently made contribu-

tions to NAGP to allow it to repay the debt sothat no future interest payments were necessary.

Ruling

The IRS claimed Scottish Powers advance of itsstock to NAGP in connection with the

PacifiCorp acquisition was a capital contribu-tion, characterised as equity, and therefore therepayments were taxable dividends.

Scottish Power argued the advance was aloan and the payments were deductible as inter-est.

The court ruled that the transaction shouldbe treated as debt.

Since the IRS could challenge its decision inthe Court of Appeals, theTax Court used an 11point analysis to determine whether the advance

was debt or equity.The factors considered were: the name given

to the documents evidencing the indebtedness;the presence of a fixed maturity date; the sourceof the payments; the right to enforce payments

of principal and interest; participation in man-agement; a status equal to or inferior tothat of regular corporate creditors; theintent of the parties; thin or adequate

capitalisation; identity of interestbetween creditor and stockholder; pay-

ment of interest only out of dividendmoney; and the corporations ability toobtain loans from outside lending insti-

tutions.

Implications

Douglas Stransky, of Sullivan &Worcester, said the IRS will continue tochallenge debt versus equity and double

dip structures, but as long as taxpayersfocus on the factors used in the courtsanalysis and ensure that those factors arewell supported, they should survive IRSchallenges.

Obviously, a taxpayer would like tohave all of the factors, but if I had to saywhat are, in general, the most importantfactors I would say its the parties clear

intent to enter into a debtor-creditorrelationship, said Stransky.

Strong evidence of such a relation-ship is the borrowers ability to repaythe funds borrowed, he added.

Although it is likely the IRS will con-tinue to make debt versus equity chal-lenges, US law allows interest deductions so theIRS may need to look at economic substancearguments in addition to debt versus equity

arguments if it is to succeed.The Obama Administration and some

Congressmen have discussed making the rulesless favourable for parties to use debt in acquisi-

tions because of the interest deduction, criticis-ing the law for favouring debt over equity.

It is likely any legislative changes would seekto neutralise the tax treatment of debt and equi-ty but no amendments of this nature have been

tabled so it could be some time before any suchchange is enacted.

Hap Shashy, of King & Spalding, said the

courts opinion will be wide-reaching because alot of taxpayers may utilise the same generalstructure as Scottish Power.

Shashy agreed with Stransky that the note

issuers ability to repay was a critical factor indeciding such cases, though taxpayers can takeother steps to meet the requirements.

If a taxpayer finds out the IRS is challeng-ing one of these types of instruments, it is help-

ful if all of the 11 factors are in place, saidShahsy.

It is also important that the parties haveacted consistently with the terms of the instru-

ment and have behaved in the way debtors andcreditors behave from the outset, he added.


US DEBT-EQUITY

How Scottish Powers US Tax Court victory could hamper IRS

The Obama Administration is unhappy US tax rules favour debt
http://www.internationaltaxreview.com/pdfs/NAGP_Opinion.pdfhttp://www.internationaltaxreview.com/Article/2973423/Tax-Disputes-Archive/IRS-likely-to-increase-debt-vs-equity-analysis-after-harsh-General-Electric-ruling.htmlhttp://www.internationaltaxreview.com/Article/2973423/Tax-Disputes-Archive/IRS-likely-to-increase-debt-vs-equity-analysis-after-harsh-General-Electric-ruling.htmlhttp://www.internationaltaxreview.com/Article/2973423/Tax-Disputes-Archive/IRS-likely-to-increase-debt-vs-equity-analysis-after-harsh-General-Electric-ruling.htmlhttp://www.internationaltaxreview.com/Article/3031764/Tax-Disputes-Archive/Hewlett-Packards-court-defeat-is-bad-news-for-US-banks.htmlhttp://www.internationaltaxreview.com/Article/3031764/Tax-Disputes-Archive/Hewlett-Packards-court-defeat-is-bad-news-for-US-banks.htmlhttp://www.sandw.com/http://www.sandw.com/http://www.sandw.com/http://www.internationaltaxreview.com/Article/3014408/Tax-Disputes-Archive/Bank-of-New-York-Mellon-begins-defence-of-STARS-schemes.htmlhttp://www.kslaw.com/http://www.kslaw.com/http://www.internationaltaxreview.com/http://www.internationaltaxreview.com/pdfs/NAGP_Opinion.pdfhttp://www.internationaltaxreview.com/Article/2973423/Tax-Disputes-Archive/IRS-likely-to-increase-debt-vs-equity-analysis-after-harsh-General-Electric-ruling.htmlhttp://www.internationaltaxreview.com/Article/2973423/Tax-Disputes-Archive/IRS-likely-to-increase-debt-vs-equity-analysis-after-harsh-General-Electric-ruling.htmlhttp://www.internationaltaxreview.com/Article/3031764/Tax-Disputes-Archive/Hewlett-Packards-court-defeat-is-bad-news-for-US-banks.htmlhttp://www.sandw.com/http://www.sandw.com/http://www.internationaltaxreview.com/Article/3014408/Tax-Disputes-Archive/Bank-of-New-York-Mellon-begins-defence-of-STARS-schemes.htmlhttp://www.kslaw.com/http://www.internationaltaxreview.com/


8/9

Joe Dalton

The US Tax Court denied Hewlett-

Packard the right to US tax deductions

claimed as part of a scheme involvingartificial generation of foreign tax credits.

The judgment does not bode well for

several banks involved in similar

disputes.

The case involves a scheme constructed byAmerican International Group-Financ ialProducts (AIG-FP) during the 1990s wherebyderivatives were traded to generate capital loss-es and foreign tax credits which could be

used by companies to lower theirUS tax liability.

AIG-FP exploited differ-ences between incomerecognition rules for

contingent interestbetween the US andthe Netherlands togenerate a stream ofpreferred dividends

and produce significantforeign tax credits.

AIG-FP trans ferredcapital to a newly formedentity, Foppingadreef, in

exchange for preferred stockand warrants to purchase additionalstock.

Foppingadreef was incorporated in the

Netherlands Antilles in 1996 and its principalplace of business and seat of management werethen transferred to Amsterdam.

Dutch bank, ABN-Amro, then acquiredcommon stock in Foppingadreef in an amount

four times greater than the initial investmentmade by AIG-FP.

Foppingadreef then lent money to ABN-Amro in exchange for contingent interest notes

(CINs).Most of the interest on the notes received by

Foppingadreef was then distributed to AIG-FPthrough periodic dividends.

The transaction enabled ABN-Amro to

obtain below-market funding with favourableregulatory treatment while AIG-FP profitedthrough receiving dividends and claiming indi-rect foreign tax credits for foreign taxes paid byFoppingadreef.

AIG-FP offered Hewlett-Packard the oppor-tunity to participate in the transaction

by buying out its shares inFoppingadreef. Hewlett-

Packard acquired AIG-FPsinterest in Foppingadreef

for $203 million.In making the

acquisition, Hewlett-

Packard also enteredthe shareholdersagreement and theput and call options on

the shares.

Foppingadreef esti-mated its Dutch income

tax liability for each year andmade semi-annual payments of

tax in guilders to the Dutch taxauthority between 1996 and 2003.

Hewlett-Packard received dividends fromFoppingadreef for all of these years and claimedforeign tax credits attributable to withholding

taxes paid to the Dutch tax authority.

Hewlett-Packard claimed morethan $176 million in indirect foreigntax credits during this period. The

court disallowed these deductionssince it characterised the transactionas debt and not equity under US taxrules.

When Hewlett-Packard exited the

transaction by transferring all of itsshares back to Foppingadreef itreported a capital loss of more than$15 million.

The court said the technology

companys investments inFoppingadreef were not valid for cap-ital-loss deductions claimed byHewlett-Packard in 2003 because the

investments were not real economic

bets but carefully structured loansmade by Hewlett-Packard toFoppingadreef which were paid back.

Hewlett-Packards investment is

more appropriately characterized asdebt, rather than equity, for Federalincome tax purposes and the taxpayeris not entitled to deduct a capital lossfor the sale of its interest in Foppingadreef, the

ruling said.

BNY Mellon & Barclays

The case is similar in nature to thedispute involv-ing the Bank of New York Mellon (BNY),heardbefore the US tax court in April, which deals withstructured trust advantaged repackaged securities

(STARS) schemes entered into with UK bankBarclays, that triggered tax benefits for both par-ties through US and UK tax rules.

The STARS schemes involved artificial cre-ation of foreign tax credits toexploit differences

between US and UK tax laws.

Other US banks including BB&T,Sovereign, Wells Fargo and Wachovia are allinvolved in similar disputes and the Hewlett-

Packard ruling suggests the Tax Court is takinga hard line with these cases.

Taxpayers will need to prove there was a trueeconomic riskin entering into the transactionsand that they were supported by a real business

purpose if they are to prevail. Hewlett-Packardwas unable to demonstrate this.

Skadden, Arps, Slate, Meagher and Flom,who counseled AIG-FP in structuring the trans-action, and represented Hewlett-Packard,

declined to comment on the case.


US DEBT-EQUITY

Hewlett-Packards court defeat is bad news for US banks

BNY Mellon is involved in a similar dispute concerning STARS schemes
https://www.ustaxcourt.gov/InOpHistoric/HEWLETTPACKARD.TCM.WPD.pdfhttp://www.internationaltaxreview.com/Article/3151463/Search/Why-business-leaders-think-US-tax-certainty-would-have.htmlhttp://www.internationaltaxreview.com/Article/3014408/Tax-Disputes-Archive/Bank-of-New-York-Mellon-begins-defence-of-STARS-schemes.htmlhttp://www.internationaltaxreview.com/Article/3014408/Tax-Disputes-Archive/Bank-of-New-York-Mellon-begins-defence-of-STARS-schemes.htmlhttp://www.internationaltaxreview.com/pdfs/IRS_trial_memorandum.pdfhttp://www.internationaltaxreview.com/pdfs/IRS_trial_memorandum.pdfhttp://www.internationaltaxreview.com/pdfs/IRS_trial_memorandum.pdfhttp://www.internationaltaxreview.com/Article/2640507/Search/IRS-targets-foreign-tax-credit-generators.html?PageId=197770&Keywords=Bank+of+New+York+Mellon&OrderType=1&PartialFields=(CATEGORYIDS%3a15111)&Brand=ITRPhttp://www.internationaltaxreview.com/Article/2640507/Search/IRS-targets-foreign-tax-credit-generators.html?PageId=197770&Keywords=Bank+of+New+York+Mellon&OrderType=1&PartialFields=(CATEGORYIDS%3a15111)&Brand=ITRPhttp://www.internationaltaxreview.com/IssueArticle/3081469/Archive/The-worlds-leading-transactional-firms.html#AsiaPacifichttp://www.internationaltaxreview.com/IssueArticle/3081469/Archive/The-worlds-leading-transactional-firms.html#AsiaPacifichttp://www.internationaltaxreview.com/https://www.ustaxcourt.gov/InOpHistoric/HEWLETTPACKARD.TCM.WPD.pdfhttp://www.internationaltaxreview.com/Article/3151463/Search/Why-business-leaders-think-US-tax-certainty-would-have.htmlhttp://www.internationaltaxreview.com/Article/3014408/Tax-Disputes-Archive/Bank-of-New-York-Mellon-begins-defence-of-STARS-schemes.htmlhttp://www.internationaltaxreview.com/pdfs/IRS_trial_memorandum.pdfhttp://www.internationaltaxreview.com/pdfs/IRS_trial_memorandum.pdfhttp://www.internationaltaxreview.com/Article/2640507/Search/IRS-targets-foreign-tax-credit-generators.html?PageId=197770&Keywords=Bank+of+New+York+Mellon&OrderType=1&PartialFields=(CATEGORYIDS%3a15111)&Brand=ITRPhttp://www.internationaltaxreview.com/IssueArticle/3081469/Archive/The-worlds-leading-transactional-firms.html#AsiaPacifichttp://www.internationaltaxreview.com/IssueArticle/3081469/Archive/The-worlds-leading-transactional-firms.html#AsiaPacifichttp://www.internationaltaxreview.com/


9/9

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Us Debt Equity Special Feb2013

Documents

Transcript of Us Debt Equity Special Feb2013