Debt vs. Equity in the Tax Court

The classification of an instrument as debt or equity affects numerous tax law provisions. While there is a lack of guidance from the IRS on determining whether an instrument constitutes debt or equity, there are many cases that have established a list of factors that assist taxpayers in making such a determination. Recently, the Tax Court applied those factors in PepsiCo Puerto Rico, Inc. , T.C. Memo. 2012-269. This item summarizes the current law and discusses the PepsiCo court’s facts and analysis.

Section 385

Congress enacted Sec. 385 in 1969 (amending it in 1989 and 1992) and gave the IRS authority to issue regulations to determine whether an interest in a corporation constitutes debt or stock in the corporation (i.e., debt or equity). The IRS, however, has not issued any regulations since T.D. 7747 was withdrawn in 1983 (T.D. 7920).

The Dixie Dairies Factors

Notwithstanding (or perhaps because of) the absence of regulations under Sec. 385, many courts have established a list of recurring factors for determining whether an interest constitutes debt or equity. The court in Dixie Dairies Corp. , 74 T.C. 476 (1980), had to decide whether advances made by a shareholder to a corporation constituted loans (i.e., debt) or capital contributions (i.e., equity).

In determining that such advances constituted equity, the court identified a list of 13 factors that have developed over time in case law and that are described below :

Name or label: “The issuance of a stock certificate indicates an equity contribution; the issuance of a bond, debenture, or note is indicative of a bona fide indebtedness” ( Estate of Mixon, 464 F.2d 394, 403 (5th Cir. 1972));
Fixed maturity date: “The presence of a fixed maturity date indicates a fixed obligation to repay, a characteristic of a debt obligation. The absence of the same on the other hand would indicate that repayment was in some way tied to the fortunes of the business, indicative of an equity advance” (id. at 404);
Source of payments: “[I]f repayment is possible only out of corporate earnings, the transaction has the appearance of a contribution of equity capital but if repayment is not dependent upon earnings, the transaction reflects a loan to the corporation” (id. at 405);
Right to enforce payments: “If there is a definite obligation to repay the advance, the transaction would take on some indicia of a loan” (id. at 405);
Participation in management (as a result of the advances): “If a stockholder’s percentage interest in the corporation or voting rights increase as a result of the transfer, it will contribute to a finding that the transfer was a contribution to capital” ( Hardman , 827 F.2d 1409, 1413 (9th Cir. 1987));
Status in relation to regular corporate creditors: “Whether the advance has a status equal to or inferior to that of regular corporate creditors is, of course, of some import in any determination of whether taxpayer here was dealing as a shareholder or a creditor” ( Estate of Mixon, 464 F.2d at 406);
Intent of the parties: “It is relevant whether the parties intended, at the time of the issuance of the debentures, to create a debtor-creditor relationship [citations omitted]. The intent of the parties, in turn, may be reflected by their subsequent acts; the manner in which the parties treat the instruments is relevant in determining their character” ( Monon Railroad , 55 T.C. 345, 357 (1970));
Identity of interest between creditor and stockholder: “If advances are made by stockholders in proportion to their respective stock ownership, an equity capital contribution is indicated [citation omitted]. A sharply disproportionate ratio between a stockholder’s percentage interest in stock and debt is, however, strongly indicative that the debt is bona fide” ( Estate of Mixon , 464 F.2d at 409);
Thinness of capital structure in relation to debt: “[T]hin capitalization is very strong evidence of a capital contribution where (1) the debt to equity ratio was initially high, (2) the parties realized the likelihood that it would go higher, and (3) substantial portions of these funds were used for the purchase of capital assets and for meeting expenses needed to commence operations” (id. at 408);
Ability of corporation to obtain credit from outside sources: “If a corporation is able to borrow funds from outside sources at the time an advance is made, the transaction has the appearance of a bona fide indebtedness. [citation omitted] . . . If no reasonable creditor would have loaned funds to the corporation at the time of the advance, an inference arises that a reasonable shareholder would likewise not so act” (id. at 410);
Use to which advances were put: “A corporation’s use of cash advances to acquire capital assets suggests that an advance is equity [citation omitted]. Use of an advance by an ongoing business to expand its operations, e.g., by acquiring an existing business, suggests that the advance is equity [citation omitted]” ( Laidlaw Transportation, Inc. , T.C. Memo 1998-232 at *79); “[I]t appears that the advances were used to meet the daily operating needs of [the company] and, therefore, indicates a bona fide indebtedness” ( Stinnett’s Pontiac Serv., Inc. , 730 F.2d 634, 640 (11th Cir. 1984));
Failure of the debtor to repay : “The failure of a corporation to repay principal amounts on the due date indicates that advances were equity” ( Laidlaw Transp. , T.C. Memo. 1998-232 at *80); and
Risk involved in making advances : “A reasonable expectation of repayment by the provider of an advance when the advance is made suggests that the advance is debt” (id. at *82).

The court in Dixie Dairies also noted that each factor is not equally significant, and that no single factor is determinative. The court further stated that “due to the myriad factual circumstances under which debt-equity questions can arise, all of the factors are not relevant to each case” ( Dixie Dairies , 74 T.C. at 493–494).

Monon Railroad

Before Dixie Dairies was decided, the court in Monon Railroad held that an instrument constituted debt notwithstanding a long maturity term and contingent timing for interest payments. In Monon Railroad , a corporation issued debentures with a 50-year maturity term with 6% stated interest. The 50-year bonds were subordinate to the issuer’s other debt. Payments of the stated interest were required annually, but only to the extent of the issuer’s available net income after payment of the issuer’s other debt (the interest payment contingency). The issuer took the position that the 50-year bonds constituted debt, which allowed the issuer a deduction for interest expense. The IRS challenged the deduction by taking the position that the 50-year bonds constituted equity.

Using a similar set of factors as Dixie Dairies , the court determined that the 50-year bonds constituted debt notwithstanding their 50-year term and the interest payment contingency.

Regarding the 50-year term, the court stated:

Although 50 years might under some circumstances be considered as a long time for the principal of a debt to be outstanding, we must take into consideration the substantial nature of the [petitioner’s] business . . . Therefore, we think that a 50-year term in the present case is not unreasonable. [ Monon Railroad , 55 T.C. at 359.]

Regarding the interest payment contingency, the court stated:

Although the interest is payable out of the [petitioner’s] available net income, and is thus liable to fluctuate according to the vicissitudes of the petitioner’s business fortunes, the amount of interest required to be paid in any year may be ascertained according to an established formula . . . That the amount of interest paid out depends upon profits and is not always the same fixed percentage of principal does not transform the debentures into equity certificates under these circumstances. [ Monon Railroad , 55 T.C. at 360, 361.]

Notice 94-47

The IRS cited Monon Railroad in Notice 94-47 when it indicated that it would scrutinize financial instruments designed to be treated as debt for U.S. federal income tax purposes but as equity for another purpose. Specifically, the IRS was concerned with instruments with equity features including an unreasonably long maturity. The IRS stated in Notice 94-47:

The Service also is aware of recent offerings of instruments that combine long maturities with substantial equity characteristics. Some taxpayers are treating these instruments as debt for federal income tax purposes, apparently based on authorities such as [ Monon Railroad ]. The Service cautions taxpayers that, even in the case of an instrument having a term of less than 50 years, Monon Railroad generally does not provide support for treating an instrument as debt for federal income tax purposes if the instrument contains significant equity characteristics not present in that case [emphasis added]. The reasonableness of an instrument’s term (including that of any relending obligation or similar arrangement) is determined based on all the facts and circumstances, including the issuer’s ability to satisfy the instrument. A maturity that is reasonable in one set of circumstances may be unreasonable in another if sufficient equity characteristics are present.

The Facts of PepsiCo

PepsiCo Global Investments (the obligor) was a Dutch limited liability company indirectly wholly owned by PepsiCo Inc., and was classified as a corporation for U.S. federal income tax purposes. The obligor, which was not a member of PepsiCo’s consolidated group, entered into an advance agreement in 1997 with a member of PepsiCo’s consolidated group (the holder) in exchange for certain notes issued by Frito Lay Inc. (the Frito Lay notes), which was a controlled subsidiary of PepsiCo.

The advance agreement provided that the obligor would pay a principal amount to the holder after 40 years, but the obligor had an unrestricted option to extend the principal payment up to an additional 15 years (the extension option). The principal amount of the advance agreement was equal to the face amount of the Frito Lay notes.

The advance agreement became perpetual if there was an uncured default on a loan receivable from a related party (i.e., the Frito Lay notes) that the obligor owned (a related-party default).

The advance agreement provided for a preferred return equal to a stated rate, which accrued on the outstanding principal. A portion of the preferred return was required to be paid to the holder annually (the cash portion), and each payment was made on the same date as interest was due on the Frito Lay notes in substantially similar amounts.

Even though the cash portion was generally required to be paid annually, the cash portion was only required to be paid to the extent that the obligor’s net cash flow exceeded the sum of (1) accrued and unpaid operating expenses and (2) capital expenditures (the cash flow requirement). To the extent that any preferred return was not paid when due, the amount was capitalized, and the payment continued to be subject to the cash flow requirement prospectively.

The holder’s right to payment under the advance agreement was subordinate to the obligor’s creditors. Subject to that subordination, the holder could declare immediately due any unpaid principal amount and accrued and unpaid preferred return (an acceleration right) upon the occurrence of (1) a dissolution or termination of the legal existence of the obligor; (2) insolvency of the obligor; or (3) receivership or appointment of a liquidator or administrator (such events will be referred to as a liquidation event).

PepsiCo wanted to treat the advance agreement as debt for Netherlands tax purposes and received a ruling from Dutch tax authorities to do so, which allowed the obligor to deduct the preferred return as interest expense from its Dutch corporate taxable income. However, to obtain the ruling, PepsiCo represented that the cash flow requirement would not prevent the payment of the preferred return.

For U.S. federal income tax purposes, PepsiCo wanted to treat the advance agreement as equity because it anticipated that the obligor’s earnings and profits would be reduced or eliminated due to losses the obligor incurred. Thus, it appeared unlikely that the holder would incur “subpart F income” (under Sec. 951) or dividends on distributions from the obligor.

The Court’s Opinion

The court in PepsiCo used the Dixie Dairies factors to determine that the advance agreements constituted equity for U.S. federal income tax purposes. Of the 13 factors, the court found that seven factors favored equity, two factors favored debt, three factors were neutral, and one factor was not relevant to the facts. The court’s analysis for each factor is summarized below:

Name or label: This factor was neutral. The advance agreement evinced neither debt nor equity ( PepsiCo , T.C. Memo. 2012-269 at *57).
Fixed maturity date: This factor was “heavily in favor of” equity. Although the advance agreement provided for a 40-year fixed term, the extension option “effectively subjected the principal amounts of the instruments to an uncertain international economic climate for an inordinate period.” The court distinguished Monon Railroad , stating that the advance agreement did not “bear many of the same debtlike indicia as the debentures” in Monon Railroad . In addition, the advance agreement became perpetual if there was a related-party default, and the court viewed the related-party default as a legitimate possibility, which ensured the advance agreement lacked an unconditional fixed repayment date (id. at *57–*66).
Source of payments: This factor provided for a debt characteristic because the payment of the preferred return substantially corresponded to payments on the Frito Lay notes in amount and timing. Thus, repayment was not dependent on corporate earnings (id. at *66–*77).
Right to enforce payments: This factor was a significant equity factor. First, the debtor had to pay only the cash portion upon the cash flow requirement’s being met. Second, a related-party default resulted in the advance agreement’s becoming perpetual. Thus, there was no unconditional obligation for the obligor to pay either the preferred return or the principal. While it was noted that the holder had an acceleration right, that right was solely upon a liquidation event and remained subordinate to the obligor’s creditors (id. at *77–*83).
Participation in management (as a result of the advances): This factor was neutral. There was no increase of control as a result of the advance agreement (id. at *83–*84).
Status in relation to regular corporate creditors: This factor favored equity because the advance agreement was unequivocally subordinate to the rights of all the obligor’s creditors (id. at *84–*88).
Intent of the parties: This factor demonstrated equity. Despite the source of payments, the intent of the obligor was not to create a definite obligation repayable upon any event due to (1) the absence of a fixed maturity date; (2) the cash flow requirement; and (3) the related-party default (id. at *88–*91).
Identity of interest between creditor and stockholder: This factor was not relevant because both the holder and the obligor were commonly controlled (id. at *91).
Thinness of capital structure in relation to debt: This factor supported equity. The ratio of the obligor’s debt to equity was viewed as “untenable” compared to industry standards when the advance agreement was entered into (id. at *91–*93).
Ability of corporation to obtain credit from outside sources: This factor demonstrated equity because an expert testified that the terms of the advance agreement would not have been replicated by an independent financing (id. at *93–*95).
Use to which advances were put: This factor favored debt. The advance agreement was entered into in exchange for the Frito Lay notes, and the interest of the Frito Lay notes was intended to fund payments of the cash portion (id. at *96–*97).
Failure of the debtor to repay: This factor was neutral because the advance agreement had not yet matured (id. at *97).
Risk involved in making advances: This factor favored equity. There was uncertainty whether the principal would be repaid due to (1) the long and conditional maturity dates; (2) the subordination of the advance agreement to other creditors; (3) the holder was not afforded legitimate creditor remedies to ensure payment of the preferred return; and (4) the advance agreement would not have been entered into by an independent creditor (id. at *97–*99).

Summary

In PepsiCo , the taxpayer achieved its desired result by treating the advance agreement as debt for Dutch tax purposes and equity for U.S. federal income tax purposes. Interestingly, the IRS argued to treat the advance agreement as debt despite its position in Monon Railroad and its concern in Notice 94-47. Overall, PepsiCo illustrates that determining whether an instrument is debt or equity requires a careful analysis notwithstanding how it is treated by other countries’ tax authorities. While courts have established lists of factors that aid taxpayers in making such a determination, the applicability and weight given to each factor is based on the facts and circumstances of each case.

Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.