Classifying Debt and Equity

by Shahzad A. Malik J.D. LL.M and Ryan C. Gaglio J.D. *

In General

"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 (Ct. Cl. 1967).]

Thus, the classification of an interest as debt or equity calls for the resolution of a question of fact in which all the facts and circumstances relative to the relationship between corporation and owner are weighed. In this regard, it should be noted that little weight is given to local law labels or characterizations. [W. O. Covey, Inc. v. Commissioner, T.C. Memo 1969-273 (T.C. 1969).] The relationship, and the interest it creates, are viewed solely from a tax law standpoint. [United States v. Snyder Bros. Co., 367 F.2d 980 (5th Cir. Ga. 1966).]

The Relevant Factors

While form alone is not determinative of the issue of debt versus equity, lack of formal indicia of debt may swing the balance in favor of equity. Likewise, the failure to cloak a purported equity instrument with the characteristics of equity may lead a court to find the existence of debt. Generally, a debt instrument is thought of as one which contains an obligation to pay a sum certain at a reasonably close fixed maturity date, or, perhaps, at some accelerated date if a default occurs; bears a fixed rate of interest; is not subordinated in priority to general or unsecured creditors; is readily transferable; and does not grant the holder the right to vote except in limited circumstances, e.g., on default. Equity, on the other hand, lacks a maturity date, normally gives the holder the right to vote or participate in management, gives the holder the right to share in the profits of the enterprise, and is subordinate to the claims of creditors.

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Debt-Equity Classification and the Tax Reform Act of 1969

The difficulties inherent in the attempt to draw a distinction between debt and equity finally led Congress, in 1969, to enact legislation authorizing the promulgation of "such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness." [IRC § 385(a).] The difficulty of providing "comprehensive and specific statutory rules of universal and equal applicability" led Congress to frame the legislation in terms of a grant of authority to prescribe Regulations. S Rep No 91-252, 91st Cong, 1st Sess 138 (1969).] Additional authority was granted in 1989 to permit regulations covering interests that "are in part stock and in part indebtedness." The debt-equity guidelines are required to set forth the factors to be taken into account in determining whether a specific interest qualifies as debt or equity, including among others:

1)     whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest,

2)     whether there is subordination to or preference over any indebtedness of the corporation,

3)     the ratio of debt to equity of the corporation,

4)     whether there is convertibility into the stock of the corporation, and

5)     the relationship between holdings of stock in the corporation and holdings of the interest in question." [IRC § 385(b).]

  
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* Shahzad A. Malik, J.D., LL.M and Ryan C. Gaglio, J.D.are the authors of Taxation of Securities Transactions.

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