How Do You
Put A Debt/Equity
Case Together?
Donald Korb
James Gadwood
Andrew Solomon
December 11, 2012
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Prior results do not guarantee a similar outcome.
Copyright ©2012 Sullivan & Cromwell LLP
How Do You Put a Debt/Equity Case
Together?
I.
Background.
A. Historically, the IRS has raised the issue of whether a loan
between related entities should be considered equity rather
than debt primarily in closely held and/or family situations.
1. For example, see Mixon v. United States, 464 F.2d 394 (5th Cir.,
1972), the case which identified 13 nonexclusive factors to be
considered by a court when deciding the issue.
2. Thus, a substantial body of case law has built up over the years
where the taxpayers involved were not publicly held companies.
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How Do You Put a Debt/Equity Case
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B. In fact, between the early 1990’s and until somewhat recently,
the IRS had not spent much time looking for and raising the
debt/equity issue, which had been a quite commonly seen
issue prior to the early 1990’s.
1. Interestingly, until this year, the last significant reported cases
dated from the 1990’s: Nestle Holdings, Inc. v. Commissioner, 70
T.C.M. 682 (1995) and Laidlaw Transportation, Inc. v.
Commissioner, 75 T.C.M. 2598 (1998).
2. Note that both of these cases did involve publicly held companies
and both were cross-border transactions.
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How Do You Put a Debt/Equity Case
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C. However, over the past couple of years, the IRS has once
again begun to focus on the debt/equity issue.
1. We have been told by an IRS Examination Team that
debt/equity is an issue in 20%-30% of all large cases and that
there are approximately 280 active cases in the LB&I inventory
right now.
2. These new cases involve almost exclusively multinational public
corporations and cross-border transactions.
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How Do You Put a Debt/Equity Case
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3. In 2011, two debt/equity cases were tried before the U.S. Tax
Court: Pepsico Puerto Rico, Inc. v. Commissioner and NA
General Partnership and Subsidiaries (ScottishPower).
a. Both cases were decided by the Tax Court this year; results for the IRS
were mixed.
b. In Scottish Power, the Court found debt characterization rather than
equity.
c. In Pepsico, the Court found equity characterization rather than debt.
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How Do You Put a Debt/Equity Case
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II. To effectively handle one of these cases, professional
advisers should be appointed at an early stage.
A. “Begin with the end in mind” – facts may eventually need to
be presented in court, privilege will need to be established
where appropriate, etc.
B. Best to start with the right advisers rather than switch half
way through – if a case is sufficiently large that it might have
to be litigated, best to start with a law firm which will be able
to take the case all the way through the process.
C. Also best to work with an accounting firm on computational
matters, reconciling tax returns to underlying books and
records, building financial models, etc.
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How Do You Put a Debt/Equity Case
Together?
D. Consider experience in the field.
1. Including international aspects.
2. Experience with litigation in the field.
3. Scale – a case could become a major exercise.
4. Cultural fit – the company may be working very closely with
the professional firm for a very long time – need to work well
together.
5. Standing with the IRS – helps to have a highly respected team
of advisers.
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How Do You Put a Debt/Equity Case
Together?
E. If it becomes a substantial issue for the company,
appropriate rules of engagement should be established
early on.
1. Briefings for senior executives by the tax director and external
advisers.
2. Briefings for the Audit Committee and/or the Board of
Directors.
3. Engagement with financial reporting teams and Group
Controller regarding any disclosure issues.
4. Engagement with treasurer and his/her team – they will need
to provide the bulk of the information and facts and need to
be very engaged.
5. Decision making – establish clear protocols to determine
when and how management need to be consulted as decisions
have to be made – need to be quick to react when necessary.
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How Do You Put a Debt/Equity Case
Together?
III. What Will Your IRS Examination Team Look Like?
A. First, there will be your assigned LBI Examination Team
(including the LBI Team Manager and the LBI Senior Team
Coordinator).
B. Then certain Specialists will be added to the assigned
Examination Team.
1. Financial Products Specialist.
2. Economist Specialist.
3. International Specialist.
C. There are others who could also become involved.
1. Inbound Financing Pilot Specialist.
2. Chief Counsel Attorneys (LBI Attorney assigned to the
Examination Team, Special Counsel (International) in Hartford,
National Office Attorneys (from Corporate and International)).
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Copyright ©2012 Sullivan & Cromwell LLP
How Do You Put a Debt/Equity Case
Together?
IV. Law.
A.
The law is rather straightforward so these cases are basically
decided by the facts (as well as how well the facts are
presented to the IRS).
B.
Nestle (taxpayer won) vs. Laidlaw (IRS won).
1.
Holistic – i.e., broad considerations:
a.
intention to create debt,
b.
reasonable expectation of repayment, and
c.
economic reality of actually creating a debtor-creditor
relationship,
vs.
C. Simply marching through a factor-by-factor analysis of the 13
Mixon factors.
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How Do You Put a Debt/Equity Case
Together?
C. Three key distinguishing features of Laidlaw.
1. The financing structure was not historic but had been marketed
to the taxpayer by a Big 6 Accounting Firm.
2. The advances were treated by the taxpayer itself as equity for
Canadian tax purposes but as debt for U.S. tax purposes.
3. The lending transactions and the debtor/creditor relationship
were not “at arm’s length.”
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How Do You Put a Debt/Equity Case
Together?
D. Do not forget:
1. There is good case law on the point that courts should focus on
the realities of the business world; that the IRS should not be
permitted to rewrite a company’s balance sheet; etc.
2. The Internal Revenue Code Section 385 tests (there are 5 of
them).
3. IRS Notice 94-47 tests (there are 8 of them).
4. The time to test whether a particular instrument is debt or
equity is ordinarily at the time the instrument is issued.
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Copyright ©2012 Sullivan & Cromwell LLP
How Do You Put a Debt/Equity Case
Together?
V. Facts, Facts, Facts.
A. Develop a “rock solid” outline of a Statement of Facts as early
as possible and use it as a guide in responding to IDRs,
developing position papers for the IRS, responding to the
Notice of Proposed Adjustment and preparing the Protest.
B. Examples of factual areas to think about covering in your
Statement of Facts.
1. History and organization of the taxpayer and the related party
lender.
2. Description of the particular financing arrangement.
3. Borrowing history/reason for the loans.
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How Do You Put a Debt/Equity Case
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B. Examples of the factual areas to think about covering in your
Statement of Facts (cont’d).
4. Mechanics of the loan process (from both the Borrower’s and the
Lender’s perspectives).
5. Capital structure of the Borrower.
6. Credit Metrics of the Borrower (debt/equity financial ratio vs.
other financial ratios).
7. Third party loans/comparable loans.
8. Terms and conditions of the loans.
9. Payment history (both interest and principal).
10. Refinancing of all/part of loans.
11. Debt payback periods.
12. Acquisitions/dispositions.
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How Do You Put a Debt/Equity Case
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C. How to Tell Your Story: Develop a Theme for your Case and
Focus on the “Key Considerations.”
1. Show the business reasons for increases in debt levels.
2. Show why additional debt made business sense from the
perspective of the capital structure of the Borrower.
3. Show the financing arrangement was historic and not brought to
you by a Big 4 Accounting Firm.
4. Show the debt is plain vanilla.
5. Show that enough cash flow was generated to pay all of the
interest and all/most/at least some of the principal or that the
remainder of the principal was repaid with refinancing proceeds.
6. Show that the projected payback period is reasonable.
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How Do You Put a Debt/Equity Case
Together?
C. How to Tell Your Story: Develop a Theme for your Case and
Focus on the “Key Considerations” (cont’d).
7. Show that the Borrower could have borrowed from a third party
lender on terms that were substantially similar to the terms of
the related-party loans (or at least that the related-party loan
terms were not a “patent distortion” of third party terms
available in the marketplace).
8. Show an acceptable financial ratio for the Borrower/consider
obtaining a Valuation Study.
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How Do You Put a Debt/Equity Case
Together?
D. Consider Developing Documentation to Support Your Theme.
1. Valuation Study.
2. Standalone Credit Rating Analysis.
3. Paper on Optimal Capital Structure.
4. Evidence of Potential Third Party Loans.
5. Analysis of Cash Flow Numbers.
6. Other Expert Reports.
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How Do You Put a Debt/Equity Case
Together?
E. When to Tell Your Story (Proactive vs. Reactive).
1. At the opening conference.
2. During the IDR process.
3. In a position paper before the NOPA is issued.
4. After the NOPA is issued.
5. In the Protest.
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How Do You Put a Debt/Equity Case
Together?
VI. Managing the Examination.
A. The opening conference.
1. Set the ground rules upfront.
2. Refer to the LBI Quality Examination Process Reference Guide.
3. Work to set a reasonable examination timeline.
4. Agree on the IDR process/do not fall behind schedule.
5. Agree on the issue resolution (NOPA) process.
6. Schedule periodic meetings with the LBI Senior Team
Coordinator (weekly?) and Team Manager (monthly?).
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Copyright ©2012 Sullivan & Cromwell LLP
How Do You Put a Debt/Equity Case
Together?
B. Consider a background briefing on the debt/equity issue as
soon as it becomes clear that it is an area of interest to the
Examination Team.
1. Orally try to get the Examination Team “to play on your field.”
2. Or perhaps offer to provide a Statement of Facts “telling your
story” in writing.
3. “He who controls the pen, controls the deal.”
C. Consider using the IDR process to “tell your story” rather
than just providing the most limited amount of information.
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How Do You Put a Debt/Equity Case
Together?
D. Try to engage the Examination Team on the debt/equity issue
sooner rather than later. The idea is to make them realize
“that there is no issue here” or “that it is better to go after
some other taxpayer (no names please) rather than you.”
Also, the more the Examination Team puts time in on the
issue, the harder it will be to convince them to drop it.
E. Consider when “to go up the line” to higher IRS management,
if that step seems appropriate.
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Copyright ©2012 Sullivan & Cromwell LLP
How Do You Put a Debt/Equity Case
Together?
F. Keep in mind that it will probably be the Financial Product
Specialist and the Economist who will determine if the
debt/equity issue is set up.
1. This means that you have to try to engage them so that you can
figure out where they are going with the issue.
2. Think about their management chain; it is different than your
assigned Examination Team’s management chain.
3. Also keep your eye on how involved the Chief Counsel lawyers
are on this issue; listen carefully to figure out if lawyers from the
National Office are taking over the case.
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Copyright ©2012 Sullivan & Cromwell LLP
How Do You Put a Debt/Equity Case
Together?
G. Is it appropriate to use experts at the examination level (or
wait until the case is in IRS Appeals or litigation)?
H. When is it appropriate to involve the U.S. and/or other
Competent Authority?
I.
Don’t forget about withholding.
J.
Try to get penalties off of the table as early as possible.
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Copyright ©2012 Sullivan & Cromwell LLP
How Do You Put a Debt/Equity Case
Together?
VII. Expert Selection Process.
A. How do you go about it?
B. When is a good time to start?
C. What are the issues where experts can be helpful?
D. Essential?
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How Do You Put a Debt/Equity Case
Together?
VIII. At some point it may be appropriate and/or
necessary to invoke competent authority
proceedings. Questions to consider:
A. Is it worth it?
B. Which competent authorities should be involved?
C. When?
D. What are the risks (the process is not necessarily within
your control)?
E. Does this lead to contractual issues between the affected
parties? Governance issues?
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Copyright ©2012 Sullivan & Cromwell LLP
How Do You Put a Debt/Equity Case
Together?
IX.
The Bottom Line. You need to find an “adult”
somewhere in the process who will understand the
issue.
Good Luck!
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