The classification of corporate obligations as debt or equity has had a long history as a contentious and difficult to resolve issue. The courts and the government have grappled with ways, over the years, to give taxpayers means to clarify given results without success.
Although the classification of an instrument as debt or equity is as difficult as it ever has been, we may now be at point where classification issues are not as relevant. Recent tax legislation (informally known as the Tax Cuts and Jobs Act (TCJA)) may have reduced (or eliminated) the importance of debt as a vehicle to reduce corporate income tax.
The first section of the piece discusses why debt may not be a useful as a planning tool after the enactment of the TCJA. The remaining section surveys the current state of the law in characterizing corporate obligations as debt or equity.
I. The Tax cuts and Jobs Act
Traditionally, corporate investors have used related-party debt as a planning device to reduce a corporation’s income tax liability. Interest is generally deductible, while dividends are not. The use of debt reduced some of the potential harshness of the double taxation scheme that the US applies (i.e., a corporation pays tax on the income and shareholders pay a second level of tax when the profits are distributed as a dividend), resulting in a form of integration.
A. Corporate Debt as a Planning Tool
This all worked fine where the corporate and individual tax rates where roughly equivalent. After the enactment of the TCJA, the rates are no longer equivalent and the individual rates are significantly greater. As a result, it is possible that corporate debt may no longer be as useful as a mechanism for corporate tax reduction. In addition, the TCJA added several new limitations on interest deductions that may make corporate debt even less attractive.
Individual investors in a C corporation may no longer find leverage beneficial. The federal tax rate on interest income can go as high as 40.8% (regular tax of 37% and net investment income tax of 3.8%), starting in 2018. This compares unfavorably with the corporate income tax rate of 21% (a 19.8% difference). The difference was only 8.4% before the enactment of the TCJA. Of course, individuals in lower tax rate brackets may still find corporate debt to be a useful tax reduction mechanism.
The current difference between corporate and individual federal rates of 19.8% is only slightly lower than the maximum qualified dividend tax rate of 23.8% (maximum rate of 20% and net investment income tax of 3.8%). However, a dividend has the advantage of not being subject to tax until distributed. In addition, distributions in excess of earnings and profits (E&P) are generally not included in gross income (and reduce stock basis).
Similarly, foreign investors in a domestic corporation may no longer find leverage to be as useful a tax reduction mechanism. The US now has a tax rate that is comparable to the corporate income tax rates of many other countries. As a result, a corporate tax deduction at the US rate of 21% (and possibly as high as 29% if state taxes are included) would not be beneficial if the home country rate is higher (e.g., Mexico has a rate of 30%). Even if the combined US tax rate (federal and state) were comparable to other countries, leverage would be at best tax-neutral (and a detriment if some of the interest were not currently deductible in the US). It should be noted that, as described below, the ability to deduct interest in the US and avoid paying tax abroad has been sharply curtailed.
Corporate debt may still be a useful vehicle in reducing shareholder level taxation. Distributions from a corporation are subject to tax to the extent of E&P. Unlike many other countries, the US does not permit distributions to be treated as a return of capital first. Imposing debt on a corporation may be a useful tool for bringing money back without having to pay tax. Where debt is imposed for this reason, it may be advisable to use the lowest amount of interest that is permitted for US tax purposes. This generally would be 100% of the applicable federal rate (AFR). IRC §§ 1274(d), 7872(e); Treas. Reg. § 1.482-2(a)(2)(iii)(B)(1)(i).
Corporate debt may also be useful in reducing shareholder level tax for certain foreign investors from certain countries where the treaty withholding rate for interest is less than the rate for dividends. Of course, the treatment of interest and dividends in the home country will need to be taken into account in deciding whether the related-party debt makes sense.
B. Interest Deductions Limitations After the TCJA
In addition to affecting the rates that made leverage beneficial, the TCJA placed additional limitations on the deductions of interest, including (i) a limitation on business interest deductions, (ii) a disallowance of interest deductions in hybrid transactions, and (iii) a base erosion minimum tax. Moreover, section 956 was not repealed by the TCJA (as had been anticipated). As a result, debt that is issued by a US shareholder to a controlled foreign corporation (CFC) continues to generally result in inclusion in the US of the E&P of the CFC (up to the amount of the debt).
Section 163(j) (after amendment by the TCJA) generally limits the deduction of business interest. The new limit is 30% of adjusted taxable income (i.e., taxable income attributable to business activities before deductions for interest and NOLs). Before 2022, adjusted taxable income is to be adjusted for depreciation, amortization, and depletion. Interest expense is reduced by any business interest income (before application of the 30% limitation). Business interest that is disallowed can be carried forward indefinitely (but subject to limitation under section 382 if an ownership change occurs).
The advent of the 30% limit on business interest may mean that testing for debt or equity may no longer be as necessary. In many cases, debt that is structured to be fully deductible will meet many of the below-described factors for categorizing a corporate obligation as debt. This will be especially true (i) if interest rates return to more normal levels (e.g., 8%), or (ii) after 2022, when the limitation is applied after deductions for depreciation, amortization and depletion.
One effective means of international tax planning is to take advantage of situations where two countries treat the same entity or transaction differently (e.g., one country treats the entity as a branch and the other treats it as a corporation). To combat this, section 267A disallows deductions for interest (as well as royalties) to a related party pursuant to a hybrid transaction (tax treatment of the item is different in the other country) or to a hybrid entity (tax classification of the entity is different in the other country). These provisions apply if the payment is not taken into account as taxable income (or a deduction is allowed) in the other country.
Section 59A imposes a 10% base erosion minimum tax on C corporations (5% for 2018). For purposes of the minimum tax, taxable income is recomputed to disallow the tax benefit of any base erosion payment. A base erosion payment is an amount paid to a related foreign party (including interest) for which a deduction is allowable, other than certain service costs with no markup. The minimum tax does not apply if the corporation has average annual gross receipts of less than $500 million (including the gross receipts of related persons), over a three taxable-year period. As a result, the benefit of related party interest deductions that meet the 30% limit may still not provide a full benefit.
II. Debt-Equity classification
In order for a payment to be characterized as interest for US income tax purposes, it must be made with respect to a bona fide debt obligation. See e.g., Treas. Reg. § 1.482-2(a)(1)(ii). The determination of whether a financial obligation constitutes debt or equity is based on principles set forth in case law and guidance issued by the Internal Revenue Service (IRS). Treas. Reg. § 1.385-1(b).
Below is a summary of the various relevant statutory and regulatory provisions, as well as the various cases and rulings.
A. Code Provisions
Section 385 of the Internal Revenue Code of 1986, as amended, (the “Code”) provides for a variety of rules that impact the classification of corporate obligations as debt or equity (or the benefits of a classification as debt). However, they do not provide for overarching classification rules or safe harbors (and only limited presumptions).
Section 385(a) grants the Treasury regulatory authority to prescribe rules on whether a corporate obligation is to be treated as debt or stock (or part-debt or part-stock). Such rules, if issued, can be for all purposes of the Code. The next subsection describes the storied history of Treasury’s attempt to finalize (and sometimes later withdraw) section 385 regulations.
Section 385(b) provides guidelines for Treasury’s regulatory authority. The regulations must set forth factors to be taken into account based on specific factual situations. The provision then lists several factors that the regulations may take into account (among others). This list should be considered in determining the classification of a corporate obligation.
The listed factors are:
- whether there is a written unconditional promise to pay an amount of money on demand or on a specified date,
- whether there was adequate consideration for the obligation (in money or equivalent value),
- whether there is an obligation to pay a fixed rate of interest on the obligation,
- whether the obligation is subordinated to other debt of the corporation (or has a preference),
- the ratio of debt to equity,
- whether the debt is convertible, and
- the relationship between the holdings of stock of the issuer and the holdings of the corporate obligation.
All of the above factors have been cited by cases as relevant (to varying degrees) in determining the classification of a corporate obligation.
Section 385(c) provides rules that require consistent treatment of a corporate obligation by a holder and issuer. The classification of a corporate obligation by an issuer (at the time of issuance) is binding on the issuer. There is a great deal of uncertainty as what conduct by the issuer binds them. The IRS has stated (as one of several arguments for debt treatment) in private rulings that the mere treatment of a corporate obligation on Schedule L (book balance sheet) binds the issuer. FSA 200003009 (Oct. 19, 1999); FSA 200004011 (Oct. 20, 1999); FSA 200003001 (Aug. 31, 1999). It appears doubtful that the non-tax treatment of a corporate obligation could be considered to be a binding classification by an issuer.
The issuer’s treatment is also binding on all holders of the obligation (unless the holder discloses the inconsistent treatment on a tax return). The classification by the issuer is not binding on the IRS.
In addition to section 385, the Code has several provisions that disallow (or limit) an interest deduction when a corporate obligation (that would otherwise be treated as debt) has too many equity-like features. Section 163(e)(5) limits the deduction of original issue discount (OID) on certain debt obligations with an excessive yield. Section 163(l) disallows the interest on debt that is payable in equity of the issuer (or a related party). Section 279 disallows the interest on corporate acquisition debt that (i) is subordinated, (ii) is convertible into equity (or is part of an investment unit with stock or an option to acquire stock), and (iii) has a debt-equity ratio of over 2 to 1 (or has projected earnings that do not exceed three times the annual interest).
Although section 385 was enacted in 1969, no regulations were finalized until 1980. The 1980 rules included many objective standards and safe harbors (and few subjective standards) for classifying a corporate obligation. The rules were controversial and were subsequently withdrawn in 1983 (on a retroactive basis).
On October 13, 2016, the IRS and the Treasury issued new rules under section 385 for determining whether related-party corporate financial obligations will be treated as debt or stock for US income tax purposes. The new regulations were issued to help limit the tax benefits of corporate inversions, but apply more broadly.
The new rules would require large taxpayers to meet a documentation requirement in order to treat a related-party obligation as debt. In addition, the new rules recharacterize certain related-party obligations as stock (even if the documentation requirement is met) if they were issued as part of a specified transaction (including, an issuance for no consideration (other than stock) or to fund a dividend to a related party).
The recharacterization rules have already come into effect. These rules generally apply to taxable years ending on or after January 19, 2017. However, debt obligations issued before April 4, 2016 are exempt from the recharacterization rules. As a result, calendar year taxpayers will need to apply these rules in 2017 with respect to debt instruments that were issued on or after April 4, 2016.
The documentation rules have not yet come into effect. These rules were originally to apply to debt obligations that were issued after December 31, 2017. Treas. Reg. § 1.385-2(d)(2)(iii). The effective date was postponed for one year to give taxpayer adequate time to implement the rules (i.e., for obligations issued after December 31, 2018). Notice 2017-36, 2017-33 IRB 208.
After President Trump came into office, the Treasury reviewed all regulations that had been issued near the end of the prior administration. The Treasury identified eight regulations (including the section 385 regulations) that potentially may need to be modified or rescinded in order to reduce the financial burden on taxpayers. Notice 2017-38, 2017-30 IRB 147.
On October 2, 2017, the Treasury issued a report to the President on its recommendation for reducing the tax regulatory burden (the “Report”). The Treasury, “Identifying and Reducing Tax Regulatory Burdens,” (Oct. 2, 2017), 2017 TNT 192-14. Included in the Report were recommendations as to the status of the section 385 regulations.
The conclusion of the Report was that the recharacterization rules serve a useful purpose of combating inversion transactions. However, the Treasury expressed a hope that future tax legislation would eliminate the tax benefits of inversion transactions and the need for the recharacterization rules. In December 2017, the TCJA was enacted. It is anticipated that Treasury will review the recharacterization rules in that light and determine if they are still needed. In the meantime, they are still in effect and must be complied with.
As to the documentation rules, the Report stated that the IRS and the Treasury were considering revoking the rules and replacing them with revised rules that are simpler and streamlined. The revised rules would have a prospective effective date. However, no action to revoke or revise the existing rules has yet been taken.
The new section 385 regulations also provide rules for general application of principals for classifying corporate obligations. These rules provide that the determination of the appropriate tax treatment of a corporate obligation is generally determined based on common law (i.e., cases and rulings) and the factors prescribed under common law. As a result, the existing cases and rulings will generally continue to apply. However, common law is not used to determine the tax treatment if the Internal Revenue Code or regulations thereunder (including the section 385 regulations) provide for a different treatment. Treas. Reg. § 1.385-1(b).
As stated, the documentation rules are not currently in effect. However, they contain useful guidance as to how to properly document that a corporate obligation should be classified as debt. These could be considered to be best practices.
To meet the documentation requirements, the taxpayer must retain complete copies of instruments and legal documents that evidence the material rights and obligations of the issuer and holder of the debt and any associated rights of other parties (e.g., guarantees). For executed documents, a copy as executed must be retained.
Taxpayers must also retain written documentation as to payments of principal and interest by the issuer to the holders (including prepayments). If the issuer did not make a payment when due and payable (or there was an event of default), written documentation must be retained as to the efforts of the holders to assert their creditor’s rights (or the basis for not asserting such rights).
In addition, a taxpayer must retain written documentation for the below described features:
- the issuer has an unconditional (and legally binding) obligation to pay a specified sum at one or more fixed dates (or on demand);
- the holders have typical creditor rights to enforce the obligation (e.g., the right to cause or trigger an event of default or acceleration for any missed payment and the right to sue to enforce the payment);
- the holders have a right to assets upon a dissolution of the issuing corporation that is superior to the rights of shareholders; and
- the issuing corporation’s financial position (as of the date of issuance) supports a reasonable expectation that the issuer intends (and has the wherewithal) to meet its obligations under the instrument.
Appropriate documentation with regard to the reasonable expectation of repayment can include cash flow projections, financial statements, business forecasts, asset appraisals, and calculations of debt-equity ratios (or other relevant financial ratios). It is permissible to assume that the debt will be satisfied by the proceeds of another borrowing by the issuer (if the assumption is reasonable). The documentation can include evidence that a third-party lender would have made the loan to the issuer under the same (or substantially similar) terms. Legally privileged documents cannot be used to satisfy the documentation requirements regarding reasonable expectation of repayment. Treas. Reg. § 1.385-2(c).
The section 385 regulations generally recharacterize as stock certain debt obligations that are issued by a corporation (or controlled partnership) to an affiliated corporation (or controlled partnership). The rules recharacterize obligations as stock (even if the documentation requirement is met) if they were issued as part of a specified transaction (including, an issuance for no consideration (other than stock) or to fund a dividend to a related party). The specified transactions that cause the recharacterization rules to apply were viewed by the government as having been commonly used to reduce US tax by earning-stripping (i.e., related party issuances of debt that does not finance a new investment in the operations of the issuer).
The recharacterization rules generally apply if either the debt issuance rule or the funding rule applies, unless an exemption applies. The debt issuance and funding rules are described below.
Under the debt issuance rule, debt is generally treated as stock for all federal tax purposes if the instrument is issued (i) in a distribution with respect to stock, (ii) in exchange for stock of an affiliated corporation, or (iii) in an exchange with an affiliated corporation for assets pursuant to a corporate reorganization. Treas. Reg. § 1.385-3(b)(2). As an example, if a subsidiary issues a note payable to a parent corporation for no consideration, the note will generally be treated as stock under the debt issuance rule.
Under the funding rule, a debt obligation is treated as stock to the extent it is issued in exchange for property (including cash) with a principal purpose of funding any of the transactions described in the previous paragraph. For this purpose, a debt obligation is deemed to have been issued with a principal purpose of funding a distribution or acquisition if it is issued within 36 months of the transaction (before or after). The funding rule can result in the bifurcation of a financial instrument into something that is treated as part-debt and part-stock for federal tax purposes. Treas. Reg. § 1.385-3(b)(3).
As an example of how the funding rule applies, assume that FP, a foreign corporation, owns 100% of Sub, a US corporation, and FS, a foreign corporation. FS lends Sub $100 million in exchange for a Sub note and then Sub distributes the $100 million in cash to FP. Under the funding rule, the $100 million Sub note would be recharacterized as stock issued to FS (unless an exemption applies). Sub would not be permitted to deduct the interest on the Sub note. After the transaction, both FP and FS would be treated as shareholders of Sub for federal tax purposes.
These recharacterization rules are extremely complicated and contain a multitude of special rules and exceptions. Exemptions from the rules exist for:
- certain short-term obligations,
- debt issued by a foreign corporation or an S corporation,
- debt that is held by an S corporation,
- debt that is issued by one member of a consolidated group to another member of such group,
- debt obligations issued before April 4, 2016 (unless substantially modified after that date),
- the first $50 million of debt that would otherwise be recharacterized, and
- distributions (and similar transactions) to the extent of accumulated E&P.
Treas. Reg. §§ 1.385-1(c)(2), (4), -3(b)(3), (c)(3)(i), (4), (g)(3); Temp. Reg. § 1.385-4T.
C. IRS Guidance and Rulings
Notice 94-47, 1994-1 CB 357 represents the most significant piece of guidance issued by the IRS on the classification of corporate obligations as debt or equity. The notice states that the IRS will scrutinize such obligations on audit to determine the appropriate classification. The IRS is more likely to pay attention to obligations that have a variety of equity features.
Like section 385, Notice 94-47 has a list of relevant factors for classification of a corporate obligation. No particular factor is determinative and the weight given to any factor depends upon all of the facts and circumstances (including the overall effect of the obligation’s debt and equity features).
The factors are:
- whether there is an unconditional promise to pay a sum certain on demand or on a fixed maturity date (that is in the reasonably foreseeable future),
- whether the holders possess the right to enforce the payment of principal and interest,
- whether the obligation is subordinate to the rights of general creditors,
- whether the obligation gives the holders the right to participate in management of the issuer,
- whether the issuer is thinly capitalized,
- whether there is an identity between the holders of the obligation and the stockholders of the issuer
- the label placed upon the obligation by the parties,
- whether the obligation was intended to be treated as debt or equity for non-tax purposes (including for purposes of government regulations, rating agencies, or financial accounting), and
- the ability of the issuer to satisfy the obligation.
The notice states that obligations with unreasonably long maturities will not generally be respected as debt. The IRS suggested that an obligation with a fifty-year term may be reasonable if the long maturity is not combined with “substantial equity characteristics.” Obligations with a shorter term may be considered to have unreasonably long maturity if the facts and circumstances suggest as much.
The IRS has resolved specific fact patterns involving whether a corporate obligation is debt or equity in only a handful of published rulings and a slightly larger number of private rulings. A summary of the published rulings is below.
- Notice 94-48, 1994-1 CB 357 – An issuance of debt by a subsidiary partnership of a corporation was treated as equity. The partnership would use the capital raised to purchase preferred stock from the corporation. The obligations were intended to be treated as equity for regulatory, rating agency, or financial accounting purposes. The IRS stated it would likely disallow the interest on such obligations under various potential legal theories.
- Rev. Rul. 85-119, 1985-2 CB 60 – Mandatory convertible debt of a bank holding company was respected as debt. At maturity, the holders were only contractually entitled to receive stock of the issuer (determined based upon the appraised value of the stock at maturity). However, the holders had the option to receive the stock or to have the issuer sell the stock on behalf of the holder and deliver cash. The holder option to choose stock or cash (and the fact that there were no other equity features) influenced the IRS to treat the obligation as debt. The IRS noted in Notice 94-47 that Revenue Ruling 85-119 is limited to its facts and that obligations that are effectively only payable in stock will generally be treated as equity.
- Rev. Rul. 90-27, 1990-1 CB 50 – Dutch-auction rate preferred stock was treated as stock even though the obligation was an investment alternative to commercial paper or short-term debt. The obligations were perpetual and the holder had no right to a fixed amount on demand or on a specified date. In addition, the obligations were subordinated and there was no guarantee of an interest-like payment (unless declared by the issuer).
- Rev. Rul. 77-437, 1977-2 CB 28 – Convertible debt was respected as debt. The IRS stated that the conversion feature did not alter the classification. However, if there is a “very high probability” that an obligation will be converted into equity, then the conversion feature would be a factor that suggests equity treatment. See also Rev. Rul. 83-98, 1983-2 CB 40.
- Rev. Rul. 68-54, 1968-1 CB 69 – Subordinated debentures were respected as debt. The debentures were nontransferable and did not provide for acceleration of maturity upon default on interest payments. The debentures had fixed interest of 7% per year, plus contingent interest of up to 1%. The debentures were not owned by any person that owned, directly or indirectly by attribution, stock of the issuer. The IRS stated that subordination, contingent interest, transfer restrictions, and the lack of acceleration upon default were all equity-like features. However, the IRS treated the debentures of debt due to following debt-like features (i) having a reasonable (ten years) fixed maturity date, (ii) payments were not dependent upon earnings or at the discretion of the issuer, (iii) the holders had priority over the claims of stockholders, (iv) the holders did not have voting or management powers, (v) default on the payment of interest gave rise to a cause of action (even though it did not accelerate the payments), (vi) there appears to be sufficient capital for the normal operations of the business, (vii) the earnings history of the issuer indicates that it is reasonable for the holder to anticipate payment of interest and principal, and (viii) the parties intended to create a debtor-creditor relationship. The structure of the debentures was designed to be treated as capital for stock exchange requirements. This fact was not mentioned as relevant to the classification of the debentures. A variation on these debentures is described in Revenue Ruling 73-122, 1973-1 CB 66, to the same result.
The IRS has only rarely resolved debt-equity classification issues in private rulings. The dearth of such rulings is due to the fact that they will not generally rule on such issues in private letter rulings (unless the facts strongly support a given classification and there are “unique and compelling” reasons). Rev. Proc. 2018-3, §4.2(1). However, there are a small number of rulings that deal with taxpayers that are under audit. In such rulings, the IRS has typically followed the factors applied by the courts (described below). See e.g., CCAM 200932049 (Mar. 10, 2009).
D. Case Law
The courts have applied a facts and circumstances test in determining whether a financial obligation is to be treated as debt or equity. Various factors have been taken into account by the courts. However, the weight given to any specific factor differs and is highly dependent upon the relevant facts and circumstances. However, no single fact or circumstance is sufficient to determine the debt or equity status of an obligation. John Kelley Co. v. Commissioner, 326 US 521 (1946); Fin Hay Realty Co. v. United States, 398 F.2d 694, 697 (3rd Cir. 1968); Notice of Prop. Rulemaking REG-108060-15, 2016-1 CB 636.
Particular scrutiny is given to purported debt that is owed by a corporation to a shareholder (or to a related person). E.g., IRC § 385(c)(5); Notice 94-47; PepsiCo PR, Inc. v. Commissioner, TC Memo 2012-269, at 51 (related party debt warrants “a more thorough and discerning examination for tax characterization purposes”). The basis for the increased scrutiny is that the element of control “suggests the opportunity to contrive a fictional debt, an opportunity less present in an arms-length transaction between strangers.” Cuyuna Realty Co. v. United States, 382 F.2d 298, 301 (Ct. Cl. 1967).
There are thousands of cases involving the correct classification of corporate obligations. Since the determination is based on the facts and circumstances, it is a challenge to enunciate any “black letter law” or themes coming out of the cases. One court stated that,
There is no dearth of cases in this province of tax law. So large is their number and disparate their facts, that for every parallel found, a qualification hides in the thicket. At most they offer tentative clues to what is debt and what is equity for tax purposes; but in the final analysis each case must rest and be decided upon its own unique factual flavor, dissimilar from all others, for the intention to create a debt is a compound of many diverse external elements pointing in the end to what is essentially a subjective conclusion.
American Processing & Sales Co. v. United States, 371 F.2d 842, 848 (Ct. Cl. 1967).
The Tax Court and most circuits of the Court of Appeals have their own unique list of factors that are relevant. Various courts have lists that range from 11 to 16 factors. Many of the factors are included in the lists described above under section 385(b) of the Code and Notice 94-47. Since in each jurisdiction no factor is determinative and the relevant weight of each factor depends upon the facts and circumstances, the list used by a court will not influence the result very often. However, the IRS and the Treasury in the preamble to the proposed section 385 regulations stated that “the courts apply inconsistent sets of factors to determine if an interest should be treated as stock or indebtedness, subjecting substantially similar fact patterns to differing analyses.” Notice of Proposed Rulemaking REG-108060-15, 2016-1 CB 636.
Almost all of the factors that are included in the list of factors used by the courts appear in the lists included in section 385(b) and Notice 94-47. Factors that do not appear on those lists include:
- reasonable expectation of repayment,
- the source of payments under the corporate obligation,
- the ability of the corporation to obtain outside financing,
- the extent to which the advance was used to acquire capital assets,
- whether required payments were made on the due date, and
- if a required payment was missed, what the holder did to protect its rights.
The Supreme Court has only once determined the classification of a corporate obligation. See John Kelley Co. However, the Court deferred to the Tax Court, under procedures that were then in effect, and did not fully analyze the obligation or indicate which factors should be taken into account in determining the classification of debt. As a result, there is no uniformity of factors related to the determination of the classification of a corporate obligation.
A reasonable expectation of repayment is a factor that has received increased importance in recent cases and may possibly be a super factor today. TIFD III-E, Inc., v. United States, 459 F.3d 220, 232 (2d Cir. 2006) (significant factor) (known as Castle Harbour II). This factor relates to whether “the funds were advanced with reasonable expectations of repayment regardless of the success of the venture or were placed at the risk of the business.” Gilbert v. Commissioner, 248 F.2d 399, 406 (2d Cir. 1957). Almost all court cases consider this risk to be a key factor (even if they did not state whether the factor was the primary one). However, the Third Circuit in Fin Hay Realty did state that the other factors are only aids in determining whether the realistic expectation test was met. 398 F.2d at 697. It is this author’s view that applying the realistic expectation as a super factor would increase the ability of taxpayers to predict the outcome of a case and would provide some measure of fairness to the classification of corporate obligations.
One issue that is frequently discussed in cases is the debt-equity ratio of the issuing corporation. There is little uniformity among the courts as to what is acceptable as a minimum ratio and how much weight to give a low ratio. Bradshaw v. United States, 683 F.2d 365 (Ct. Cl. 1982) (11-1 ratio permitted); Liflans Corp. v. United States, 390 F.2d 965, 970 (Ct. Cl. 1968) (per curium) (8 to 1 is considered safe); Boris Bittker & James Eustice, “Federal Income Taxation of Corporations and Shareholders,” ¶ 4.04 (7th ed.) (“It is usually assumed, however, that a ratio of debt to equity that does not exceed 3 to 1 will withstand attack. A less favorable ratio is likely to invite attention.”). It may be possible to argue that a 2 to 1 ratio is safe since Congress used that level in section 279. IRC § 279(b)(4)(A). The 1980 section 385 regulations would have generally provided for a safe harbor debt-equity ratio of 10 to 1. Treas. Reg. § 1.385-6(f)(3) (before withdrawal in 1983). The IRS in Revenue Ruling 68-54, 1968-1 CB 69, permitted a debt-equity ratio of 20 to 1. It is very possible that the debt-equity ratio may now just be a factor in the reasonable expectation of repayment test.
Determining whether a corporate obligation is to be classified as debt or equity remains a perilous undertaking. The lack of uniformity as to the factors to be taken into account and the weight to give to each makes it a challenge to predict how a court, and even sometimes the IRS, will conclude. Attempts by the IRS and the Treasury to provide some rationality to this area have not increased the amount of certainty.
It is possible that the changes brought in by the TCJA may reduce the importance of this hoary classification issue. The change in rates drastically reduce the benefits of related party debt and the limitation on business interest may mean that there will be less of a reason to issue debt with high debt to equity ratios.