Me, Myself, and My Subsidiary: A Shift in the Intent Standard in Related-Party Hybrid Debt Cases

Stafford Smiley
Victor Jaramillo[1]

Over the last few years, multinational corporations have faced increased scrutiny from regulators and the media for their aggressive tax avoidance practices. One common practice is the use of related-party debt to achieve base erosion and profit shifting-in particular, using hybrid mismatch arrangements between related companies to exploit how different countries characterize a transaction or an instrument for tax purposes. The fact that only a small number of taxpayers-typically those with significant capital income and access to sophisticated tax planning techniques are able to take advantage of such arrangements contributes to the growing public criticism.

Cross-border hybrid instruments add an additional layer of difficulty to traditional U.S. debt-equity analysis by bringing into play the laws of a second, foreign country. While the laws of another country do not determine the characterization of an instrument for U.S. tax purposes, they may affect the analysis of these transactions under U.S. tax law. This is because in any cross-border transaction governed by foreign law, it is that foreign law that determines the rights and obligations of the parties. U.S. tax law then defines the consequences of these rights and obligations.

This column focuses on the approach U.S. courts use to determine the proper characterization of hybrid instruments in related-company financing transactions. Specifically, this column analyzes how the Tax Court has recently applied a particularly important factor in the debt-equity rubric-the parties' intent to enter into a debtor-creditor relationship-when such hybrid instruments are governed by foreign law.

This column contends that the Tax Court's most recently decided related-party hybrid instrument case, Pepsico Puerto Rico, established a new, more taxpayer-friendly standard for analyzing the intent requirement[1]. If, as one recent article contends, courts are analyzing debt-equity cases with a greater focus on what the parties to the transaction intended[2], then Pepsico stands for the proposition that related parties can have different intentions in different jurisdictions with respect to the same instrument and still have the intent factor weigh in their favor.

The Growing Scrutiny of Tax Planning Practices

The taxation of multinational corporations, or lack thereof, has become a hot topic. The effective tax rate of multinationals was brought into the spotlight by a 2011 New York Times story on General Electric's tax practices[3]. About a year later, in a story on Apple's tax strategies, the New York Times introduced its readers to the "Double Irish With a Dutch Sandwich"[4]. These articles set the stage for the Senate Permanent Subcommittee on Investigations to conduct an in-depth review of offshore profit shifting by U.S.-based multinationals-notably, its 9/20/12 hearing on the tax practices of Microsoft and Hewlett-Packard and its 5/21/13 meeting to hear the testimony of Apple executives[5].

But the document that has garnered the most attention to date is the recently published report on base erosion and profit shifting (BEPS Report) by the Organization for Economic Cooperation and Development (OECD)[6]. The G-8 meetings in June and November of 2012 served as the impetus for the publication of this report, with the final recommendations of the OECD expected soon. The BEPS Report highlights some of the key ways multinational corporations exploit differences in domestic and foreign tax laws to eliminate or significantly reduce taxation. Also, it identifies "key pressure areas" for base erosion and profit shifting, including hybrid mismatch arrangements and related party debt-financing[7].

According to the BEPS Report and an accompanying report devoted to hybrid mismatching arrangements[8], hybrid mismatching arrangements are used to exploit differences in countries' tax rules. Some of the most common elements underlying hybrid mismatch arrangements are hybrid instruments, hybrid entities, dual residence entities, and hybrid transfers. Hybrid instruments exploit differences in the tax treatment of the instrument in the countries involved. Hybrid entities, which are often used in conjunction with hybrid instruments, are entities treated as transparent for tax purposes in one country and as non-transparent in another. The result desired by employing either or both of these hybrids in a transaction is typically to attain either a deduction in both countries related to the same obligation, or a deduction in one country without recognizing an inclusion in the other.

The tax policy issues generated by the use of hybrid mismatch agreements include:

1. The loss of tax revenue when viewing the countries involved collectively.
2. The unintended competitive advantages attained by multinational corporations over small and medium-sized enterprises that cannot use mismatch opportunities.
3. The distortive effect on investment opportunities resulting from unintended tax benefits.
4. The effect on public confidence in the fairness of the tax system resulting from the ability of only a select group of taxpayers being able to reduce their taxes.

In light of the BEPS Report, the use of hybrid instruments by multinationals will likely receive continued attention from regulators and, as a result, courts. While the approach employed by U.S. courts in analyzing this issue is far from bright line, recent case law seems to establish a new trend in using the debt-equity analysis to review hybrid instruments.

Looking at the Multifactor Debt-Equity Test in a New Light

Courts have long employed the factors developed in Estate of Mixon, or some variation thereof, to analyze whether an instrument or transfer is debt or equity[9]. Because no one factor is determinative, and the weight given to each factor depends on the facts and circumstances of each individual transaction, reconciling debt-equity cases is often a difficult task.

An article published in the journal Tax Law in 2012, by Thomas D. Greenaway and Michelle L. Marion, proposes to simplify traditional debt equity analysis[10]. The article expounds upon the premise of the grandfather of debt-equity analysis, an article written by William T. Plumb and published in 1971[11] - that the purpose of the debt-equity inquiry is to find the parties' true intent-and contends that most debt equity cases can be decided by asking a simple question: "Did the parties to the transaction reasonably expect the funds would be repaid in full?" According to Greenaway and Marion, all the important factors of the current multifactor test applied by courts are captured by this question. The difficult debt-equity question can then be answered by the courts by ascertaining the parties' intent, with the help of experts, taking into account primarily risk and creditworthiness.

Greenaway and Marion walk through the Mixon factors and categorize them as either useful, malleable, neutral, or deadwood. The factors viewed as determinative are:

1. Intent of the parties.
2. Thinness of capital structure.
3. Credit risk.
4. Source of "interest" payments.

The authors find other factors not helpful "because they are generally within a taxpayer's control and ample case law exists to support almost any situation." After analyzing the significant related-party debt-equity cases decided by the Tax Court-four of the five upheld the taxpayer's characterization-and other recent debt-equity cases, the authors conclude that the answer to their question provides the same result as the courts' application of the complicated, and antiquated, multifactor test. Indeed, the authors note that some of the cases explicitly answer the question they proposed or a close analogy.

While the authors' proposed truncated approach provides a helpful alternative to the debt-equity analysis employed by courts, the ultimate goal of the analysis is to determine the parties' intent, and therefore, this factor should be afforded the most weight. The different variations of the debt-equity test applied by courts have rephrased this factor in a variety of ways but always seek to answer the same question: whether the parties intended to form a creditor-debtor relationship. The intent of the parties is not a two-way street: both parties must intend that the advance be either debt or equity[12]. But proving what the parties intended is often difficult, especially in the related party context where both parties are part of the same economic entity. The task becomes more complex when the same instrument is drafted to yield one characterization under the laws of the United States and a second characterization under the laws of a second jurisdiction.

The Parties' Intent Under Foreign Law

Although foreign law does not dictate whether an instrument is treated as debt or equity under U.S. law, U.S. courts do look to foreign law to define the rights and obligations of the parties[13]. U.S. law is then applied to determine the tax consequences of the parties' rights and obligations under foreign law[14]. This concept is no different than what occurs under purely domestic law. For example, if a purported debt obligation is invalid under the laws of the state that govern the instrument, no debt can be said to arise for U.S. federal tax purposes[15].

The Coleman case is useful to demonstrate this dynamic in the cross-border context[16]. In Coleman, the taxpayer acquired its interest in previously leased computer equipment through a "forward sale" in which a U.K. corporation sold its residual interest in the equipment to the taxpayer's partnership. The U.K. corporation had purchased the equipment, transferred title to lender-lessors, and arranged the initial lease between the lender-lessors and user-lessees. The transactions were structured in this manner to provide a benefit to the lender-lessors under U.K. tax law[17]. Notably, the documents evidencing the initial sale, subsequent lease, and residual purchase option of the equipment stated that the lender-lessors owned the equipment.

The U.S. government contended that the agreements showed that the lender-lessors, and not the U.K. corporation, were the owners of the equipment. Because the taxpayer derived his interest from the U.K. corporation, he was not entitled to depreciation or interest deductions. The court held that the taxpayer did not have a depreciable interest in the equipment because the taxpayer failed to present, at a minimum, "strong proof" that the U.K. corporation from which it derived its interest bore the burdens and benefits of ownership of the equipment. In reaching its conclusion, the court noted that the U.K. corporation and the lender-lessors intended, in form and in substance, to vest title in the equipment in the lender-lessors.

At a minimum, Coleman stands for the proposition that a taxpayer must adduce some proof that facts or representations made in another jurisdiction should not be determinative when applying U.S. law. In the related-party hybrid instrument context, Coleman may support the proposition that the parties' intent for entering into the transaction under the law governing the instrument should be the intent that a U.S. court considers for purposes of its analysis.

Shift in the Requisite Intent Requirement of the Debt-Equity Analysis

The importance of the parties' intent to enter into a debtor-creditor relationship cannot be overstated. A number of cases explicitly recognize the importance of the parties' intent[18]. The intent requirement (or some variation of this requirement) is a necessary but not sufficient factor for finding debt[19].

A recent cross-border debt-equity case, NA General Partnership (ScottishPower), highlights the importance of the intent factor in a debt-equity analysis[20]. In Scottish Power, a U.K. utility company("Parent") was looking to acquire a utility company in the United States ("Target"). To effect the transaction, Parent formed two U.K. corporations, which elected to be treated as disregarded entities for U.S. tax purposes; the two U.K. corporations, in turn, formed a U.S. partnership that elected to be treated as a corporation for U.S. tax purposes ("DRH")[21]. Target was acquired using Parent company's stock, and in return, DRH issued a note to the Parent company for 75% of the value of Parent shares used in the transaction[22]. The court found that the instrument DRH issued to Parent was debt for U.S. tax purposes. The court's analysis of the 11 debt-equity factors prescribed by the Ninth Circuit[23] spans approximately 27 pages, 8 of which are devoted to an analysis of the parties' intent[24]. Even though the transaction was between related parties, the court addressed the actions of both parties in reaching its finding that both parties intended the advance to be debt-noting that both parties recorded the loan notes as debt on their books and records at all times relevant, consistently recognized the loan notes as debt in their correspondence, and represented to the SEC that the loan notes were debt. The amount of time spent by the court discussing whether the parties intended the advance to be debt or equity reinforces the importance of this factor. However, the transaction at issue involved a hybrid entity and not a hybrid instrument. Therefore, the court was not confronted with a situation in which the parties had a different intention for entering into the transaction.

The most recent intra-company debt-equity case involving a hybrid instrument is Pepsico Puerto Rico[25]. The case is unique in the sense that the taxpayer was seeking to treat the hybrid instrument as equity for U.S. tax purposes, whereas in most cases the taxpayer is seeking to treat an instrument as debt in order to get interest deductions. A detailed description of the immensely complex transaction at issue is beyond the scope of this article[26]. Briefly, in Pepsico, the taxpayer's foreign subsidiaries issued "advance agreements" to the taxpayer's domestic subsidiaries as part of a global restructuring implemented as a result of a change in the Netherlands-U.S. tax treaty and new overseas business objectives. The terms of the advance agreements were negotiated with the Dutch Revenue Service in connection with obtaining a Dutch tax ruling to ensure the advance agreements would be treated as debt for Dutch tax purposes. The court walked through the debt-equity factors and held that the instrument more closely resembled equity.

The court's analysis is important in two respects. The court respected the separateness of the parties. The court understood that in a global market place, a company will conduct business in different jurisdictions through its legally distinct subsidiaries, and transactions between related parties are not to be disregarded merely because the parties are related. While the court recognized that these transactions merit close scrutiny, it refused to integrate the parties into one economic unit.

Regarding the intent factor, the court began its discussion by noting that the key to the debt-equity determination is the parties' actual intent. The court then stated: "Petitioners [Pepsico], engaging in legitimate tax planning, designed the advance agreements with an expectation that the instruments would be characterized as equity for U.S. federal income tax purposes and as debt under Dutch tax law. . . . Similarly, petitioners' actions during the taxable years at issue do not subvert or vitiate their clear intentions to create a legitimate hybrid instrument."

The court could simply have said that the parties' statements to a foreign tax authority are not controlling or binding on a U.S. court, and that for U.S. tax purposes, the parties intended to enter into a debtor-creditor relationship. Instead, the court seems to create a new intent standard for cross-border related-party transactions: the parties can have different intents in different jurisdictions with respect to the same instrument or transaction.

That the court refused to view the parties as one integrated economic unit and acknowledged their right to plan transactions so as to benefit from the different treatment they receive in different jurisdictions[27], seems to signal a shift in the analysis of the parties' intent in related-party hybrid instrument cases.

A Hypothetical Transaction to Test the Theory

A hypothetical transaction can illustrate the application of the new standard. Suppose WidgeCo is the ultimate parent company of a multinational corporation engaged in the production of widgets. WidgeCo is a corporation formed under the laws of foreign country X and has a wholly owned subsidiary, ForeignHoldCo (FHC), a corporation also formed under the laws of foreign country X, which holds the operating subsidiaries in foreign countries X, Y, and Z.

Suppose further that WidgeCo has decided to expand its business by purchasing a manufacturing company operating in the United States. WidgeCo forms USHoldCo (UHC), a corporation formed under the laws of the United States, to effect the purchase.

The following describes the steps that complete the transaction. WidgeCo borrows $1 million from unrelated investors in foreign country X. WidgeCo then purchases USOperatingCo (OpCo), a corporation formed under the laws of the United States whose shares are owned by persons unrelated to WidgeCo, for $1 million. WidgeCo contributes OpCo's shares to UHC.

UHC then forms a new subsidiary, DRE, under the laws of foreign country X. DRE is a corporation that elects to be treated as a disregarded entity for U.S. tax purposes. Country X recognizes the separate existence of DRE. DRE then offers UHC the opportunity to purchase 1,000 additional shares in DRE for $1 million on the following terms (the "Offer"): $1,000 upon acceptance of the offer; $100,000 not before 12/31/2013; $150,000 not before 12/31/2014; $200,000 not before 12/31/2015; $250,000 not before 12/31/2016; and $299,000 not before 12/31/2017. Excluding the $1,000 due upon acceptance, amounts due under the Offer are required to be paid only when "called" by the DRE board of directors. Such calls cannot be made before the date specified above. The Offer is governed by the laws of country X.

Immediately after accepting the Offer, UHC sells DRE to FHC for $817,000, the present value of the Offer if all calls are made by the DRE board at the earliest possible time. FHC continues to treat DRE as a disregarded entity for U.S. tax purposes. UHC takes the position that the Offer is debt for U.S. tax purposes, and payments made to DRE, which is now owned by its foreign sister company, represent principal and interest.

Foreign country X does not consider the Offer to be indebtedness because UHC does not have an obligation to make any payments-i.e., the DRE board is under no obligation to make the calls, so there is no debt. If and when the amounts are called, foreign country X does not consider the payments made by UHC to DRE income to DRE; they are akin to capital contributions under Section 351 of the Internal Revenue Code.

Before the Pepsico decision, the government could have argued that the parties expressed their actual intent for entering into the transaction to the foreign country. Because the instrument is governed by the laws of foreign country X, the implicit representation made to the foreign country regarding their intent-that they did not intend to enter into a debtor-creditor relationship-should control for purposes of analyzing their intent under U.S. tax law. Thus, under Coleman, the taxpayer would have to show that the intent expressed to the foreign country is not what the parties intended with respect to the transaction.

However, the Pepsico case appears to undermine this argument. The fact that DRE and UHC did not intend to enter into a debtor-creditor relationship for foreign country X purposes seems irrelevant under the intent factor announced in Pepsico. If the parties designed the transaction so it would be treated as equity in country X and debt in the United States, the parties would have had the intent to create a hybrid instrument. The intent factor in the multifactor test would likely weigh in favor of the taxpayer.

Conclusion

It is often difficult to reconcile the results of the multifactor test applied by U.S. courts to distinguish debt from equity. However, there appears to be a trend towards a simplified application of the test that seeks only to determine the parties' intent for entering into the transaction. Though the key to the debt-equity question is arguably whether the parties to the transaction intended to enter into a debtor-creditor relationship, Pepsico seems to expand the required intent requisite for a related party hybrid instrument cases to include an intention to create a hybrid instrument. Thus, it is arguable that a new, more taxpayer-friendly test is available in these cases.

[1] Stafford Smiley is Faculty Director and Professor, Graduate Tax Program, at the Georgetown University Law Center. Professor Smiley is also Senior Counsel to Caplin & Drysdale, Chartered, Washington, D.C. Victor Jaramillo is an associate with Caplin & Drysdale.
[2] Pepsico Puerto Rico, TC Memo 2012-269 , RIA TC Memo ¶2012-269, 104 CCH TCM 322
[3] Greenaway and Marion, "A Simpler Debt-Equity Test," 66 Tax Law. 73 (2012).
[4] Kocieniewski, "G.E.'s Strategies Let It Avoid Taxes Altogether," N.Y. Times, 3/25/11.
[5] Duhigg and Kocieniewski, How Apple Sidesteps Billions in Taxes," N.Y. Times, 4/28/12.
[6] Video of the 9/20/12 hearing can be seen at:
http://www.hsgac.senate.gov/subcommittees/investigations/hearings/offshore-profit-shifting-and-the-us-tax-code.
The 5/21/13 hearing can be seen at:
http://www.hsgac.senate.gov/subcommittees/investigations/hearings/offshore-profit-shifting-and-the-us-tax-code_-part-2.
[7] OECD (2013), Addressing Base Erosion and Profit Shifting, OECD Publishing (cited throughout as the "BEPS Report"). http://dx.doi.org/10.1787/9789264192744-en.
[8] In addition to a need for increased transparency on the effective tax rates of multinational corporations
and those areas noted above, the BEPS Report also identified key pressure areas related to: i) international mismatches in entity characterization; ii) application of treaty concepts to profits derived from the delivery of digital goods and services; iii) the tax treatment of captive insurance and other intra-group financial transactions; iv) transfer pricing; v) the effectiveness of anti-avoidance measures; and vi) the availability of harmful preferential regimes. BEPS Report, p. 6.
[9] OECD (2012), Hybrid Mismatch Arrangements: Tax Policy and Compliance Issues, OECD Publishing.
[10] Estate of Mixon, 30 AFTR 2d 72-5094 , 464 F2d 394, 72-2 USTC ¶9537 (CA-5, 1972). The factors are:
(1) the name given to the instrument; (2) the presence or absence of a fixed maturity date; (3) the source of principal payments; (4) the right to enforce payments; (5) the right to participate in management; (6) the status of the advance in relation to other debts; (7) the intent of the parties; (8) "thin" or adequate capitalization; (9)identity of interest between creditor and stockholder; (10) the source of "interest" payments; (11) creditworthiness; (12) the use of the advance to buy capital assets; and (13) payment history. Id. at 402.
[11] Greenaway and Marion, "A Simpler Debt-Equity Test," 66 Tax Law 73 (2012).
[12] Plumb, "The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal," 26 Tax L. Rev. 369 (1971).
[13] See e.g., Cuyuna Realty Co., 20 AFTR 2d 5172 , 180 Ct Cl 879, 382 F2d 298, 67-2 USTC ¶9571 (Cl. Ct., 1967) ("To constitute a valid debt, there must not only be a legal obligation to repay, but the money must have been advanced with reasonable belief at the time that it would be repaid."); Fisher, 54 TC 905 (1970) (In determining whether a bona fide debtor-creditor relationship exists, "[a]n essential element is whether there exists a good-faith intent on the part of the recipient of the funds to make repayment and a good-faith intent on the part of the person advancing the funds to enforce payment.").
[14] See TAM. 9748005 (8/19/97) ("dual tax ownership will not be a concern in the United States when it is solely the result of differing U.S. and foreign legal standards of tax ownership being applied to the same facts because tax ownership is determined under U.S. legal standards without regard to the tax ownership treatment obtained under foreign law.") (emphasis added).
[15] See Biddle, 19 AFTR 1253 , 302 US 573, 82 L Ed 431, 38-1 USTC ¶9040, 1938-1 CB 309 (1938) (holding that U.S. tax principles determine who pays a foreign tax and, under those principles, the person who is considered to pay the foreign tax is the person on whom foreign law imposes legal liability for the tax); Sherwood Properties, Inc., 89 TC 651 (1987) ("In the instant case, the amalgamation was made pursuant to Canadian law. Therefore, to determine when an exchange began, i.e., when title, possession of, or right to the use of property or stock passed pursuant to the amalgamation, we must look to Canadian law.") (internal citations omitted).
[16] Gilman, 53 F.2d 47, 10 AFTR 595 (CA-8, 1931).
[17] Coleman, 87 TC 178 (1986).
[18] U.K. tax law provided for first-year expensing of equipment costs by the title holder, in this case, the lender-lessor.
[19] See e.g. Estate of Chism, 12 AFTR 2d 5300 , 322 F2d 956, 63-2 USTC ¶9640 (CA-9, 1963) ("The significant fact is the intent of [the taxpayer] when he took the money"); Litton Business Systems, Inc., 61 TC 367 (1973) ("In view of the many decided cases in [the debt-equity] area, we think the determinative question, to which an evaluation of the various independent factors should ultimately point, is as follows: Was there 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 relationship?"); Geftman, 82 AFTR 2d 98-5617 , 154 F3d 61, 98-2 USTC ¶50630 (CA-3, 1998); Hewlett-Packard Co., TC Memo 2012-135 , RIA TC Memo ¶2012-135, 103 CCH TCM 1736 .
[20] See Merck & Co, Inc., 107 AFTR 2d 2011-2596 , 652 F3d 475, 2011-1 USTC ¶50461 (CA-3, 2011).
[21] NA General Partnership, TC Memo 2012-172 , RIA TC Memo ¶2012-172, 103 CCH TCM 1916.
[22] The U.S. Treasury targeted this type of structure in regulations promulgated under Section 894(c) .
[23] The two disregarded entities issued additional shares to Parent equal to 25% of the value of Parent shares used in the transaction.
[24] An appeal in ScottishPower would be to the Ninth Circuit, so the court applied the debt-equity factors used there. See Hardman, 60 AFTR 2d 87-5651 , 827 F2d 1409, 87-2 USTC ¶9523 (CA-9, 1987). The two factors not included in the Hardman factors are the use of the advance to buy capital assets and payment history. Payment history was discussed by the ScottishPower court in the "Parties' Intent" section.
[25] To provide some context, the court devoted four pages to its discussions on each of subordination and creditworthiness.
[26] Pepsico Puerto Rico, TC Memo 2012-269 , RIA TC Memo ¶2012-269, 104 CCH TCM 322 .
[27] For a detailed discussion of the Pepsico case, see Cummings, "Pepsico and Debt Equity," 138 Tax Notes 111 (1/7/13).
[28] In a footnote, the court stated that "Transactions are often purposefully structured to produce favorable tax consequences, and such planning, alone, does not compel the disallowance of the transaction's tax effects."

"Me, Myself, and My Subsidiary: A Shift in the Intent Standard in Related-Party Hybrid Debt Cases" published in Corporate Taxation, Volume 40, Issue 5, September/October 2013.  © 2013 by Thomson Reuters/Tax & Accounting.  Reprinted with permission.  All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of Thomson Reuters/Tax & Accounting.