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Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Tuesday, November 14, 2017

Judge Kozinski On The 'Timeless And Tiresome' Debt/Equity Distinction

Hewlett-Packard v. Commissioner, Nos. 14-73047 &  14-73048 (9th Cir. Nov. 14, 2017) (Kozinski, J.):

Summary:  The panel affirmed the Tax Court’s decision on a petition for redetermination of federal income tax deficiencies that turned on whether an investment by taxpayer Hewlett-Packard (HP) could be treated as equity for which HP could claim foreign tax credits.

HP bought preferred stock in Foppingadreef Investments (FOP), a Dutch company. FOP bought contingent interest notes, from which FOP’s preferred stock received dividends that HP claimed as foreign tax credits. HP claimed millions in foreign tax credits between 1997 and 2003, then exercised its option to sell its preferred shares for a capital loss of more than $16 million. The TaxCourt characterized the transaction as debt, thus upholding the deficiency for the credits.

Acknowledging a circuit split over whether the debt/equity question is one of law, fact or a mix of the two, the panel explained that the best way to read circuit precedent is that the test is “primarily directed” at determining whether the parties subjectively intended to craft an instrument that is more debt-like or equity-like, taking into account eleven factors set forth in A.R. Lantz Co. v. United States, 424 F.2d 1330, 1333 (9th Cir. 1970). The panel concluded that the Tax Court didn’t err in finding that HP’s investment is best characterized as a debt.

The panel also upheld the Tax Court’s determination that HP’s purported capital loss, which can be deducted, was really a fee paid for a tax shelter, which cannot be deducted. 

Opinion:  It’s a timeless and tiresome question of American tax law: Is a transaction debt or equity? The extremes answer themselves. The classic equity investment entitles the investor to participate in management and share the (potentially limitless) profits — but only after those holding preferred interests have been paid. High risk, high reward. The classic debt instrument, by contrast, entitles an investor to preferred and limited payments for a fixed period. Low risk, predictable reward. But a vast hinterland of hybrid financial arrangements lurks in the middle.

Despite the boundless ingenuity of financial engineering, tax law insists on pretending that an instrument is either debt or equity, then treating it accordingly — with sharply different consequences for the taxpayer. A corporation’s interest payments on debt are deductible, for example, while the dividends it pays to equity holders are not. This black-orwhite tax treatment gives taxpayers an incentive to conjure up complex instruments that give them the perfect blend of economic and tax benefits. Taxpayer gamesmanship, in turn, puts courts in the ungainly position of casting about for bright lines along an exceedingly cloudy spectrum. See generally Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations and Shareholders ¶ 4.02 (7th ed. 2000).

This case puts us in that awkward position with an unusual twist. In the textbook example, a taxpaying corporation wants an investment to be treated as debt so it can deduct the interest payments. Here, Hewlett-Packard (“HP”) wants its investment in a foreign entity to be treated as equity, so that HP will be entitled to the foreign tax credits that the entity — a so-called “FTC generator” — produces. The United States taxes the worldwide income of domestic corporations, but gives them a credit against their domestic taxes for foreign taxes they (or a subsidiary) pay. FTC generators are entities that churn out foreign credits for U.S. multinationals, which companies typically desire if they pay foreign taxes at a lower average rate than domestic taxes. See Stafford Smiley & Michael Lloyd, Foreign Tax Credit Generators, 39 J. Corp. Tax’n 3, 4–5 (2012). No small sum is on the line: The transaction here saved HP (and lost Treasury) millions of dollars.

But HP is entitled to the foreign tax credits only if it owned at least 10% of the voting stock and received dividends — in other words, if the investment was really equity, not debt. I.R.C. § 902(a). So, was it? ...

[T]he Tax Court made no error in concluding that the investment was debt.

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