In Rev. Rul. 85-119, the IRS ruled that certain instruments issued by a bank holding company are debt for US federal income tax purposes. The IRS found that the issuer and holder of the instruments intended to create a
debtor-creditor relationship. The instruments were publicly issued, widely held and not held proportionately to the bank holding company’s stock. They were designated by the parties as debt, and amounts designated as interest were payable quarterly, irrespective of earnings, at a floating rate comparable to the market rate for similar instruments. Any default on the payment of such amounts resulted in a legally enforceable right to the holders against the issuer for payment of the amount in default. The instruments had a 12-year term. The issuer was not thinly capitalized and its debt-to-equity ratio was within the industry norm. The holders were not entitled to vote or participate in management of the issuer.
The IRS found that all of these factors supported debt classification, but also found that other factors supported equity classification. These include the subordination of the rights of the holders to the rights of general creditors,
and a convertibility feature at maturity.
The IRS noted, however, that upon insolvency or bankruptcy, the holders had the status of creditors, and despite having their claims be subordinated to other general creditors, were still entitled to priority over the claims of the shareholders of the issuer. In addition, although the instruments were convertible into the stock of the issuer at maturity, the fair market value of the stock issued to the holders upon such conversion had to be equal to the
principal amount of the instruments. This conversion was to be at the election of the holders, and if a holder were not to elect to receive stock, the issuer would have to sell such amount of stock on behalf of the non-electing holder in a secondary offering with the net cash proceeds to be delivered to the holder. Such net cash proceeds had to equal the principal amount of the instrument. Failure of the issuer to perform its obligation with respect to delivering such cash proceeds would constitute a cause of action for money damages under state law.
All in all, the IRS found that the instruments at issue in Rev. Rul. 85-119 are debt for US federal income tax purposes. However, in Notice 94-47, the IRS emphasized that Rev. Rul. 85-119 is limited to its own facts, and that
instruments that are similar to the notes at issue in the ruling but that, on balance, are more equity-like are unlikely to qualify as debt for US federal income tax purposes. In particular, the IRS stated that an instrument would not qualify as debt if it has terms substantially identical to the notes in Rev. Rul. 85-119, except for a provision that (1) requires the holder to accept payment of principal solely in stock of the issuer, (2) structures the right to elect cash in such a way as to ensure the holder would choose stock or (3) is nominally payable in cash but does not in substance give the holder the right to receive cash because, for example, the instrument is secured by the stock and is non-recourse to the issuer.
Notice 94-47 provides that the characterization of an instrument for US federal income tax purposes depends on the terms of the instrument and all surrounding facts and circumstances. Among the factors that may be considered in making such a determination are: (1) whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity date that is in the reasonably foreseeable future, (2) whether holders possess the right to enforce the payment of principal and interest, (3) whether the rights of the holders of the instrument are subordinate to rights of general creditors, (4) whether the instruments give the holders the right to participate in the management of the issuer, (5) whether the issuer is thinly capitalized, (6) whether there is identity between holders of the instruments and stockholders of the issuer, (7) the label placed upon the instrument by the parties, (8) whether the instrument is intended to be treated as debt or equity for non-tax purposes, including regulatory, rating agency or financial accounting purposes and (9) the realistic expectation of repayment. The weight given to any factor depends upon all the facts and circumstances. No particular factor is conclusive in making the determination of whether an instrument constitutes debt or equity.
The various factors listed in Notice 94-47 are “… aids in answering the ultimate question whether the investment, analyzed in terms of its economic reality, constitutes risk capital entirely subject to the fortunes of the corporate venture or represents a strict debtor-creditor relationship”. The important issue is whether there was “… a genuine intention to create a debt, with a reasonable expectation of repayment, and did that intention comport with the economic reality of creating a debtor-creditor
Notice 94-47 was issued in response to a number of transactions in which instruments were issued that were designed to be treated as debt for US federal income tax purposes but as equity for regulatory, rating agency or
financial accounting purposes. The instruments typically contained a combination of debt and equity characteristics. The Notice states that, upon examination, the IRS will scrutinize instruments of this type to determine if
their purported status as debt for US federal income tax purposes is appropriate. The courts have also applied various factors in determining the classification of an instrument as debt or equity. No one-factor controls, and all relevant factors must be considered.