US tax law does not recognize hybrids as being more than one, unifies instruments. For tax purposes, an instrument is treated as either debt, equity, a forward, or an option, among other possibilities. Interest payments on debt instruments are deductible, while dividends on equity securities are not. In addition, premium payments on options are not includible or deductible until exercise, lapse, etc. Taxation of most forward instruments is deferred until settlement. The chief result that Wall Street is trying to achieve is the creation of instruments that obtain equity treatment for the regulatory, rating agency, and financial accounting purposes, while at the same time preserving their status as debt for US tax purposes in order to obtain the highly desired interest deduction for their clients. This is the type of hybrid that will be the focus of this article.
II. Debt VS. Equity Characterization
Distinguishing between debt and equity for the US tax purposes is not a simple task. The determination is a highly factual one and has been the subject of numerous court cases and a few Internal Revenue Services (hereinafter:IRS) releases and rulings. Although legislative attempts have been made in the past, no clear set of rules has been established. In 1969, Congress enacted Section 385. which provided the Treasury Department (hereinafter: the Treasury) with the authority to issue regulations addressing the determination of whether issues securities qualify as debt or equity. Later, during the early 1980s, the Treasury issued final regulations under Section 385 addressing the debt/equity distinction. However, the regulations were later withdrawn due to the immediate proliferation of hybrid instruments that took maximum advantage of the regulations.
Though the Treasury has not been successful in utilizing its regulatory authority under Section 385, Congress has amended the section twice since its enactment in 1969. In 1989, Section 385 was amended to provide the Treasury the authority to determine whether an instrument is part equity and part debt (i.e. to bifurcate an instrument). In 1992, Section 385(c) was added, requiring the holder of a security to treat the security in a manner that is consistent with that of the issuer, unless properly disclosed on the holder’s return.
Presently, case law, IRS rulings and IRS releases that make the distinction between debt and equity govern the tax treatment of hybrid instruments. Some of the more prevalent factors considered by the courts and the IRS in making the distinction between debt and equity will be analysed below. This article will then conclude with an analysis of the taxation of specific hybrid products.
A. Case law factors
The courts have never relied on any one factor to determine whether securities issues by a corporation represent debt or equity. As no single factor is controlling the courts make the debt/equity distinction by considering and applying a long list of factors to the facts and circumstances of each case. A scholarly law review article by William T. Plumb, Jr concisely lists and groups the majority of factors utilized by courts. Plumb’s list is summarized in the following table
Many tax professionals consider Plumb’s article to be the most definitive work o the issues and it is often used as a starting point in considering the debt/equity distinction. However, it must be noted that as none of the factors are conclusive and the weight given to each varies among jurisdictions and courts, it is important to consider all factors in light of the circumstances giving rise to the security when structuring and issuing such instruments.