Hewlett-Packard Company And Consolidated Subsidiaries, Petitioner V. Commissioner Of Internal Revenue, Respondent    Tax Court Judge: Goeke, Joseph Robert.

How did HP miss this?

Debt versus equity has been forgotten by many tax planners.  In the old days before small business and investors flocked to  limited liability companies and S-corporations, tax planners had to be vigilient is watching out for “thinly capitalized” corporations.    Most tax planners have forgotten about section 385, which determines when a loan is a debt or disquised preferred stock.

International tax law for Americans still focus on debt versus equity.    A corporate repayment of a loan properly classified for taxes as preferred stock changes a tax free event to a taxable event.  Or as in the case, of HP’, its  tax loss  ruled to be a  a non-deductible capital loss.

Here is what happened:

HP purchased an interest in a foreign corporation in 1996. A separate foreign shareholder held an interest in the foreign corporation that was four times greater than HP’s. The foreign corporation’s business activities were effectively limited by its articles of incorporation and a shareholders agreement to include only the purchase of contingent interest notes from the separate foreign shareholder.

As part of HP’s acquisition of its interest in the foreign corporation, HP contemporaneously purchased a put option from the separate foreign shareholder. The option gave HP the right to put its shares in the foreign corporation to the foreign shareholder in January 2003 or January 2007 or upon the occurrence of particular events that were beyond the control of the parties. The put amount was defined as the fair market value of the shares on the respective option exercise dates. The put agreement was referenced in the shareholders agreement, to which the foreign corporation was a party.

The shareholders agreement also afforded HP, upon the occurrence of certain events, the exclusive authority to convene a shareholders meeting at which the shareholders could (1) cause the foreign corporation to reduce its capital in order to redeem or repurchase HP’s shares, or (2) cause the foreign corporation to dissolve. HP anticipated receiving dividends from its investment in the foreign corporation and claiming substantial direct and indirect foreign tax credits associated with those distributions.

The Judge Ruling was:
1.  Held: HP’s investment in the foreign corporation is more appropriately characterized as a loan for Federal income tax purposes.
2. Held: further, HP is not entitled to deduct a capital loss in connection with its exit from the transaction.

So how does a firm as big as HP make this type of mistake?  Did HP believe they had a great tax team?  Or was their tax team like their tablet, a bust?

The Judge noted the following:  “The parties disagree about whether HP’s investment in FOP should be treated as equity or as debt for Federal income tax purposes. HP asserts that it made an equity investment in FOP, whereas respondent argues that HP merely advanced funds to FOP and expected a return consisting of principal and predetermined interest payments.

“Classification of an interest as debt or equity “must be considered in the context of the overall transaction.” Hardman v. United States, 827 F.2d 1409, 1411 (9th Cir. 1987). “Substance, not form, controls the characterization of a taxable transaction. Courts will not tolerate the use of mere formalisms solely to alter tax liabilities.” Id. at 1411 (citations omitted).

Generally, the focus of the debt versus-equity inquiry narrows to whether there was an 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. Litton Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973).

“The key to this determination is primarily the taxpayer’s actual intent, as revealed by the circumstances and condition of the transfer. Bauer v. Commissioner, 748 F.2d 1365, 1367-1368 (9th Cir. 1984), rev’g, T.C. Memo. 1983-120;  A. R. Lantz Co. v. United States, 424 F.2d 1330, 1333 (9th Cir. 1970); see also United States v. Uneco, Inc. (In re Uneco, Inc.), 532 F.2d 1204, 1209 (8th Cir. 1976) (in resolving debt-equity questions, both objective and subjective evidence of a taxpayer’s intent are considered and given weight in the light of the particular circumstances of a case).

“The U.S. Court of Appeals for the Ninth Circuit  has listed the following factors for determining whether an advance to a corporation gives rise to a bona fide debt as opposed to an equity investment: (1) the labels on the documents evidencing the alleged indebtedness; (2) the presence or absence of a maturity date; (3) the source of payments; (4) the right of the alleged lender to enforce payment; (5) participation in management; (6) a status equal to or inferior to that of regular corporate creditors; (7) the intent of the parties; (8) the adequacy of the (supposed) borrower’s capitalization; (9) whether stockholders’ advances to the corporation are in the same proportion as their equity ownership in the corporation; (10) the payment of interest out of only “dividend money”; and (11) the borrower’s ability to obtain loans from outside lenders. A.R. Lantz Co., 424 F.2d at 1333 (citing O.H. Kruse Grain & Milling v. Commissioner, 279 F.2d 123, 125-126 (9th Cir. 1960), aff’g T.C. Memo. 1959-110).13

“The list is not exclusive, and no factor is determinative. See Welch v. Commissioner, 204 F.3d 1228, 1230 (9th Cir. 2000), aff’g T.C. Memo. 1998-121; see also John Kelley Co. v. Commissioner, 326 U.S. 521, 530 (1946) (“There is no one characteristic, not even exclusion from management, which can be said to be decisive in the determination of whether the obligations are risk investments * * * or debts.”).

“… The Intent of the Parties (Factor 7)

“[T]he inquiry of a court in resolving the debt-equity issue is primarily directed at ascertaining the intent of the parties”. A.R. Lantz Co., 424 F.2d at 1333 (citing Taft v. Commissioner, 314 F.2d 620 (9th Cir. 1963), aff’g in part, rev’g in part T.C. Memo. 1961-230). The critical factor in finding that an investment is in substance a loan is to “ask whether, when the funds were advanced, the parties actually intended repayment.” Welch v. Commissioner, 204 F.3d at 1230 (citing Clark v. Commissioner, 266 F.2d 698, 710-711 (1959), remanding T.C. Memo. 1957-129, and Bergersen v. Commissioner, 109 F.3d 56, 59 (1st Cir. 1997), aff’g T.C. Memo. 1995-424). When HP’s FOP investment is viewed in its entirety, it becomes clear that HP never intended to absorb the risk of the FOP venture. Rather, it sought a definite obligation, repayable in any event.

“Although HP had the option to remain in the transaction until 2007, the tax benefits of the transaction ceased in 2003, and HP always intended to exercise its 2003 put right with ABN. The put agreement assured HP that it would receive full repayment of principal in 2003. ABN, the counterparty to the transaction also defined the venture as a seven-year term investment for regulatory purposes.”

“HP argues that the parties intended that it would receive FOP’s preferred stock and accordingly be treated for tax purposes as an equity holder. HP failed to articulate what the parties’ intentions were regarding the actual rights and obligations ascribed to them by their participation in the transaction.

“It is this latter intent which is important to our inquiry. See CMA Consol., Inc. & Subs. v. Commissioner, T.C. Memo. 2005-16  (“The resolution of a debt versus equity question involves consideration of the substance and reality and not merely the form. Form used as a subterfuge to shield the real essence of a transaction should not control.” (citing A.R Lantz Co., 424 F.2d at 1334)).”

In summary,  your tax planner can learn by HP’s mistakes.