Posted by: Robert Horwitz | December 20, 2017

Is It Debt? Is It Equity? Let the Tax Court Decide by Robert S. Horwitz

A question that frequently arises in tax cases is whether a transaction is debt or equity. As Judge Alex Kosinski recently noted in Hewlett-Packard, Inc. v Commissioner, Dkt. 14-73047 (9th Cir., Nov. 14, 2016),, it is a “timeless and tiresome question of American tax law”.  In arriving at the answer, which was “we defer to the Tax Court,“ the Ninth Circuit made several digressions.  First the facts.

Normally, a corporation wants an investment to be treated as debt so it can deduct interest. Hewlett-Packard  (HP) treated its investment as equity and claimed millions in foreign tax credits (FTCs).  AIG Financial Products created a Dutch company, FOP, whose sole business was to acquire and hold contingent interest notes.  The common stock in FOP was held by a Dutch Bank, ABN.  HP paid AIG $200 million for the preferred stock in FOP.   It also paid ABN a fee for a put that allowed it to sell the shares to the bank in either 2003 or 2007.   FOP paid Holland taxes on the accrued interest on the notes.  As preferred shareholder, HP received the interest from the notes as dividends and claimed FTCs for the taxes FOP paid.  After claiming millions of dollars in FTCs between 1999 and 2003, HP exercised the put and sold the preferred shares to ABN for a $16 million loss.  Claiming that HP had purchased a tax avoidance scheme, the IRS disallowed the FTCs and the capital loss.   The Tax Court held that the transaction was debt and disallowed the FTCs.  It held that HP failed to meet its burden of proof on the capital loss.  HP appealed.

In affirming, the Ninth Circuit first looked at whether the debt-equity issue was a question of fact, of law or a mix of the two. Based on its past precedent, the Ninth Circuit views it as a question of law, but noted that there is a split in the circuits on the question.  This led to the first philosophical digression:

We hazard a few observations on this split. First, the distinction between fact and law is notoriously fuzzy, and can turn as much on convention as logic. See, e.g., Nathan Isaacs, The Law and the Facts, 22 Colum. L. Rev. 1 (1922). Second, calling this a mixed question rather than a factual one doesn’t add much focus: If it’s a mixed question, we still ask whether the trial court “based its ruling on an erroneous view of the law or on a clearly erroneous assessment of the evidence.” Cooter & Gell v. Hartmarx Corp., 496 U.S. 384, 405 (1990). But this just means that “[w]hen an appellate court reviews a district court’s factual findings, the abuse of discretion and clearly erroneous standards are indistinguishable.” Id. at 401. Thus, calling this a “mixed question” succeeds only in pushing the conceptual conundrum back one step: Are we reviewing a factual finding or not?

Because corporate tax planning often “involves abstruse transactions that generalist appellate courts are ill-equipped to untangle ,” the Ninth Circuit decided that the best approach was to defer to the Tax Court.

The Ninth Circuit next discussed its traditional approach to resolving the debt-equity question: application of a non-exclusive eleven-factor test that it described as not a “bean-counting exercise” but a test meant to guide a court in resolving the factual issue. It then digressed on whether the issue is one of intent, as it had intimated in earlier cases:

We think the best way to read our precedent is as follows: Our test is “primarily directed” at determining whether the parties subjectively intended to craft an instrument that is more debt-like or equity-like. A quest for subjective intent always requires objective evidence, hence the eleven factors. On this account, all factors on the list could be described as “evidence of intent.” Direct, objective evidence of intent—say, an email from an executive stating he wishes to create an unalloyed debt instrument—is one of the eleven, and it matters. But assertions of intent don’t resolve our inquiry, which considers all the “circumstances and conditions” that speak to subjective intent. Bauer, 748 F.2d at 1368. Proclaiming an intent to create an instrument that is “debt” or “equity” doesn’t make it so.

Our precedent’s preoccupation with intent is nonetheless a little puzzling, since it suggests that a taxpayer could achieve debt treatment for an instrument that functions as equity (or vice versa), so long as he had the right state of mind in crafting the instrument. Were we writing on a barren slate, we might say that our test is simply directed at determining whether an instrument functions more like debt or equity. There’s nothing magical about intent. Nonetheless, we believe our circuit’s roundabout intent-based test merges with this simple function test in all but a few outlandish cases.

After these musings, the Ninth Circuit had no difficulty reaching its decision: the Tax Court didn’t err in finding that the transaction was best characterized as debt, resulting in the FTCs being disallowed.  The Tax Court also did not err in determining that HP purchased the put as part of an integrated transaction.  The Tax Court’s determination that the “capital loss” was really a fee to participate in a tax shelter was not clearly erroneous.  Thus disallowance of the capital loss was also affirmed.  One part of HP’s agreement with AIG didn’t help its claim that the transaction was not a tax scam:  “A clawback agreement even obligated AIG to compensate HP if HP didn’t get its desired tax results.  HP almost got its desired tax results.”

Along with Pritired 1, LLC v. United States, 816 F. Supp. 2d 693 (S.D. Iowa 2011), and the STARS transaction cases (Bank of New York v. Commissioner, 801 F.3rd 104 (2nd Cir. 2015) aff’g 140 T.C. 15 and 111 AFTR 2nd 2012-1472 (SD NY)), this case involved the IRS’s challenge to what it terms “foreign tax credit generators.” These cases involve complex financial structures whose primary impact is to generate foreign tax credits for major corporations.  It is not the normal debt-equity case in which a taxpayer funds an operating business in which it has an ownership interest.  Maybe what the Ninth Circuit finds “timeless and tiresome” is the shenanigans major corporations engage in to reduce their tax liabilities.

For more information please contact Robert S. or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at




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