University of Chicago Tax Conference November 7, Is Debt Really Different in a Partnership?

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University of Chicago Tax Conference November 7, 2014 Is Debt Really Different in a Partnership? Speaker: Steven Schneider, Goulston & Storrs PC Moderator: David Schnabel, Debevoise & Plimpton Commentator:
University of Chicago Tax Conference November 7, 2014 Is Debt Really Different in a Partnership? Speaker: Steven Schneider, Goulston & Storrs PC Moderator: David Schnabel, Debevoise & Plimpton Commentator: Bahar Schippel, Snell & Wilmer, LLP Commentator: Heather Field, University of California Hastings 1 Topics to Cover I. Introduction II. III. Do taxpayers want debt or equity it depends General state of the law: debt vs. equity IV. The conundrum of the preferred equity V. Law addressing debt-like equity VI. Solving the puzzle 2 1 I. INTRODUCTION 3 Courts Say the Test is the Same, But... In 1964, the Tax Court in Hambuechen started the analysis with an assumption that the test is the same as it would be in the corporate context. Despite the appealing simplicity and logic of having a single debt-equity test, partnerships clearly add a level of complexity. For example, the Hambuechen case did not address the so-called Culbertson line of Supreme Court cases requiring that the parties in good faith and acting with a business purpose intended to join together to carry on a business or venture (sometimes called the totality of the circumstances test. Partnerships also have special disguised sale rules that can recast equity as debt independent of the traditional debt-equity test. The recent Castle Harbour line of cases also imply that the test is the same, but then proceed to use terms like overwhelmingly in the nature of [debt] and muddy the waters. Further, a subset of cases raise questions as to whether Section 704(e) creates a separate rule that overrides the Culbertson requirement that there be an intent to share profits as co-owners if the interest tested in a capital interest in a capital-intensive partnership. 4 2 Debt-Like Preferred Equity Issue A series of recent cases have demonstrated the power of subchapter K to shift income, deductions, and tax credits between partners. All of the cases involved debt-like preferred equity ( Debt-Like Equity ). Debt-Like Equity is when a debt-like passive investor is treated as a partner and receives the full benefits of subchapter K. The current debt-equity ( D/E ) principles are generally designed to limit debt treatment, thereby prohibiting (mostly) corporations from deducting dividends on preferred equity. In the partnership context, debt treatment has less benefits because there is no level of corporate taxation to reduce with the interest deduction. However, unlike corporations, partnerships are more flexible vehicles to move capital in and out tax efficiently, and thus equity treatment is often preferred. The question is, should Debt-Like Equity always be entitled to these partnership benefits? 5 Debt-Like Equity Example Compare and contrast tax treatment of three investor classes. o Pure Common. o Pure Preferred. o Hybrid Preferred. Should 1% make a difference? Pure Common Pure Preferred $99M $100M $100M 100% preferred Hybrid Preferred 99% common 99% preferred; 1% common LLC 6 3 Debt-Like Equity Example Taxed as a Corporation Assume traditional debt-equity test would respect preferred as equity Should checking the box make it easier for Pure Preferred to be equity? What if preferred would be 351(g) non-qualified preferred? Pure Common Pure Preferred Hybrid Preferred LLC 7 Debt-Like Equity Example Taxed as a Partnership Assume traditional debt-equity test would respect preferred as equity Assume disguised sale rules not applicable since no offsetting distribution planned. Reg (a)(1) How do Culbertson and Luna fit it? Castle Harbour? Application of Section 704(e)? How does Historic Boardwalk fit in? Should it matter what type of credits are being syndicated? Pure Common Pure Preferred Hybrid Preferred LLC 8 4 What s the bottom line? Traditional debt-equity principles are still reliable. If a taxpayer wants debt treatment they can feel comfortable relying on the traditional corporate common law debt-equity authorities as the test to prove debt. o o These authorities provide the baseline test regardless of the type of borrower. When defining debt, courts have consistently applied these rules. Traditional Culbertson partnership equity tests are still reliable. If a taxpayer wants equity treatment for preferred equity in the partnership context, they can feel comfortable if they both (1) fail the traditional common law debt test; and (2) satisfy the common law Culbertson totality of the circumstances test including having a meaningful amount of true common profit sharing. 9 What s the bottom line? There is some gray if Culbertson is not met. o o o There is a gray area for Debt-Like Equity that isn t clearly debt under the traditional debt-equity test but doesn t satisfy the Culbertson totality of the circumstances test. If this other category is not clearly debt and not clearly equity then what is it? Court cases focus only on the issue at hand (does the interest qualify as partnership equity), but don t necessarily answer the logical next question of do you now treat it as debt or something else? In the corporate context, there is much more widespread acceptance of pure preferred that would not satisfy the Culbertson test. Thus you have the oddity of the ability to check-the-box for partnership treatment and put someone s equity treatment at risk. 10 5 II. DO TAXPAYERS WANT DEBT OR EQUITY It depends 11 Benefits of Debt Treatment Avoids corporate level tax. o Interest expense is deductible by the corporation Loan can provide needed tax basis for payor Can avoid or reduce tax to foreign recipient. o Fixed-rate portfolio interest is not taxed to foreign investor, even if not from a treaty country o Interest generally subject to lower treaty withholding rates (even participating interest) Can avoid Unrelated Business Taxable Income (UBTI) Foreign and UBTI investor benefits apply regardless of whether investee is a corporation or partnership 12 6 Benefits of Equity Treatment Equity treatment that qualifies for Sections 351 or 721 can defer tax on built-in gain from contributed property Payors may prefer equity treatment as a way to avoid cancellation of debt income if the instrument is not repaid Corporate investors may prefer equity treatment to benefit from the dividends received deduction. Many additional benefits for equity treatment in partnerships 13 THE KEYS TO THE KINGDOM Equity treatment in Subchapter K 14 7 Benefits of Subchapter K No entity-level income tax Partnerships provide for tax-efficient entrances and exits: o Enter tax-free without being part of a control group o Contribute property with debt in excess of basis on a tax-deferred basis o Receive in-kind distributions tax-free and dissolve the entity tax-free o Receive tax-deferred debt-financed cash distributions 15 Benefits of Subchapter K Ability to specially allocate income, deductions, and credits among partners Equity treatment can also provide character benefits to some investors, such as individual investors receiving the benefit of a flow-through of capital gains that does not occur with debt Potential for tax basis movement among assets (e.g., distributing high-basis asset to a partner with a low outside basis) Ability to adjust inside asset basis to equal outside basis, allowing a basis step up upon a sale of interests. Ability to issue compensatory profits interests in a tax-efficient manner 16 8 III. GENERAL STATE OF THE LAW Debt vs. Equity 17 The Continuum of Instruments in the Market Straight fixed rate mortgages Banks often receive warrants or equity kickers in addition to pure loan Mezzanine loans, but with non-participating interest Participating loans Preferred equity Preferred equity with limited common equity Debt or preferred equity that is convertible into common Pure common equity 18 9 Big Picture Defining Debt vs. Equity Debt vs. Equity is the ultimate facts & circumstances test. John Kelley Co. v. Commissioner, 326 U.S. 521 (1946) Straight debt: An unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor s income or the lack thereof. Gilbert v. Comm'r, 248 F2d 399, 402 (2d Cir. 1957) The ultimate question is 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 loan for which repayment was expected regardless of the success of the venture. Dixie Dairies Corp. v. Comm., 74 T.C. 476 (1980) [T]he significant factor in differentiating between the two be 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. TIFD III-E, Inc. v. U.S., 459 F.3d 220 (CA 2) 2006 (Castle Harbour II) 19 Bifurcation of Instruments Farley Realty Corp. v. Comm r, 230 F.2d 909 (CA 2) Clean debt instrument included both fixed interest plus 50% interest in the net increase in value of the real property on sale. No cap on participation and 50% profit share had no maturity date. Court treated the net profit share as equity, despite intent to treat as debt instrument. Court concluded that individual can occupy dual status as equity and debt holder. Richmond, Fredericksburg & Potomac Railroad Co v. Comm r, 37 AFTR 2d (CA 4) 1975 (bifurcation of uncapped participation component of socalled guaranteed stock ) Value of conversion feature. Section 171 disallows value of conversion premium in the amount of amortizable bond premium National Can Corp. v. U.S. 687 F.2d 1107 (7th Cir. 1982) (no interest amortization for conversion premium, but did not bifurcate instrument into debt and equity) Rev. Rul (right to convert into affiliate stock a separate property right) 20 10 Section 385 Congress Tries In 1969, Section 385 attempted to create a legislative framework limited to corporations Absent taxpayer disclosure, characterization by issuer is binding on issuer and holders (but not the IRS) Regulations shall set forth D/E factors, which may include the following o 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, o whether there is subordination to or preference over any indebtedness of the corporation o the ratio of debt to equity of the corporation o whether there is convertibility into the stock of the corporation o the relationship between holdings of stock in the corporation and holdings of the interest in question (i.e., substantial proportionality) 21 Section 385 Regulations Fail IRS issued Section 385 final regulations December 31, 1980 with April 30, 1981 prospective effective date. T.D Postponed further, and ultimately repealed as not fully representing the IRS/Treasury view on debt/equity. T.D Repealed Section 385 regulations allowed proportionately held debt and equity to be respected separately, but applied a heighted standard o If held in substantial proportion Hybrid instruments (convertible into stock or certain contingent payments) were treated as equity if debt and equity held in substantial proportion. Reg (c) Excess debt treated as equity (if a financial institution ordinarily making loans would not have made that loan). Reg (f)(2) o If not held in substantial proportion, the regulations looked at the value of the equity features, respecting it as debt of the equity features were less than 50% of the total value. Reg (a) 22 11 Case Law Factors Fin Hay Realty Fin Hay Realty Co. v. U.S., 398 F.2d 694 (3d Cir.1968). Advances recast as equity. Corporation needed funds for basic operation, no set maturity date, repayment dependent on profits, and loans were in proportion to stock ownership. Cited 16 factors used by courts generally: (1) the intent of the parties; (2) the identity between creditors and shareholders; (3) the extent of participation in management by the holder of the instrument; (4) the ability of the corporation to obtain funds from outside sources; (5) the thinness of the capital structure in relation to debt; (6) the risk involved; (7) the formal indicia of the arrangement; (8) the relative position of the obligees as to other creditors regarding the payment of interest and principal; (9) the voting power of the holder of the instrument; (10) the provision of a fixed rate of interest; (11) a contingency on the obligation to repay; (12) the source of the interest payments; (13) the presence or absence of a fixed maturity date; (14) a provision for redemption by the corporation; (15) a provision for redemption at the option of the holder; and (16) the timing of the advance with reference to the organization of the corporation. 23 IRS Jumps Back Into the Ring Notice Hybrid instrument concern: Notice states that recent instruments have been issued that are designed to be treated as debt for federal income tax purposes but as equity for regulatory, rating agency, or financial accounting purposes. Of particular concern were instruments with an unreasonably long maturity or an ability to repay the instrument s principal with the issuer s stock. Notice was not limited on its face to corporations. Cited 8 factors relevant to debt-equity determination: (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 of the instruments possess the right to enforce the payment of principal and interest; (3) whether the rights of the holders of the instruments 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 instruments by the parties; and (8) whether the instruments are intended to be treated as debt or equity for non-tax purposes, including regulatory, rating agency, or financial accounting purposes IV. THE CONUNDRUM OF THE PREFERRED EQUITY 25 Equity-Like Debt Equity-Like Debt is the prime target of current debt-equity principles The traditional taxpayer goal is to get Equity-Like Debt to be treated as debt to obtain the benefits of an interest deduction by payor and/or favorable interest income treatment by recipient This is the type of investment that the Notice 94-47, Section 385, and case law factors are designed to address Although inherently fact-specific, the current rules reasonably hit the target Potential for introduction of limited safe harbors 26 13 Debt-Like Equity This is the context where the current rules are lacking Debt-Like Equity is not the prime target of traditional debt-equity principles Debt-Like Equity is the target of specialty rules that extend beyond traditional debt-equity principles but based on similar principles Congress has currently addressed Debt-Like Equity o In the corporate context by penalizing non-qualified preferred stock o To a limited fashion in the partnership context by taxing disguised sales 27 The Current Problem Debt-Like Equity In Partnerships Partnership Flexibility. Partnerships open the door to creative tax planning, particularly when special allocations are involved. Special allocations have been used to shift tax credits between partners and shift phantom income to tax-indifferent partners Current anti-abuse rules. Section 704(b) and 704(c) limitations on special allocations have been tightened in recent years to help. There are also proposed rules to further tighten the Section 707(a) disguised sale rules The doughnut hole partner classification. Despite the anti-abuse rules, there remains a fundamental gray area with Debt-Like Equity as to whether a person rises to the level of being a partner 28 14 Recent Cases Involving Debt-Like Equity Castle Harbour (income shifting to Debt-Like Equity partner) Historic Boardwalk (rehabilitation credit shifting to Debt-Like Equity partner) Pritired LLC (foreign tax credit shifting from Debt-Like Equity partner) 29 Castle Harbour Saga Basic Facts Corporation owned fully depreciated aircraft and sought financing from non- US tax-indifferent investors in a manner that temporarily shifted material noncash taxable income to the foreign accommodation party. The Dutch banks, who contributed about 18% of the partnership s capital and provided no services or management. were allocated, for tax purposes, 98% of most of its taxable income. According to the court, the actual distributions to be made to the banks, however, were arranged so that they would receive, according to a previously agreed schedule, the reimbursement of their investment, plus an annual return at an agreed rate near 9%, plus a small share in any unexpectedly large profits. The detailed facts were complex, but in essence the excess taxable income to the Dutch banks was achieved because the bulk of the taxable income was offset with 704(b) depreciation from the aircraft that was not matched with taxable deductions Castle Harbour Saga Overview of Cases Castle Harbour I: District Court held for taxpayer under traditional debtequity principles, focused on the broad partnership definition in Section 761 with little focus on Culbertson. (TIFD III-E v. U.S., 342 F. Supp. 2 nd 94 (D. Conn. 2004) Castle Harbour II: Court of Appeals, reversed, holding for the IRS that taxpayer was not a partner. TIFD III-E v. U.S., 459 F.3d 220 (CA 2) Castle Harbour III: District Court held for taxpayer again, this time relying on 704(e). TIFD III-E v. U.S., 660 F Supp 2d 367 (D. Conn. 2009) Castle Harbour IV: Court of Appeals reversed again, concluded that even under 704(e), taxpayer was not treated as a partner. TIFD III-E v. U.S., 666 F3d 836 (CA 2) Castle Harbour II Appeals Court Reversed Court of Appeals reversed and held Dutch banks were not treated as partners The court concluded that this was a structured transaction designed to give only superficial profit and loss sharing that functioned in the manner of a repayment of a secured loan. The banks, as a consequence of these arrangements, did not meaningfully share the risks of the partnership business Ruled that District Court had errors in their legal analysis: o In rejecting the government s contention that the Dutch banks were not bona fide equity partners for tax purposes, the court relied essentially upon the sham-transactions test to the exclusion of the test of totality-of-thecircumstances set forth by the Supreme Court in Commissioner v. Culbertson. o Further, the court agreed with the IRS that the facts compel the conclusion that the bank s interest was not a bona fide equity participation 32 16 Castle Harbour III District Court Rules Again for Taxpayer In this second district court decision, the issue of 704(e) was introduced which provides that a person shall be recognized as a partner for purposes of this subtitle if he owns a capital interest in a partnership in which capital is a material income-producing factor Court concluded that 704(e) is not limited to family partnerships Court concluded that the Dutch banks were the real owners of their respective capital interests Court concluded that the Dutch banks had a true capital interest that entitled them to capital upon liquidation of the partnership Court concluded that even though the Dutch banks contribution was held in secured assets, capital was a material income producing factor of the partnership noting that the regulation looks to whether the gross income of the business, rather than a particular participating partner s capital contribution is income producing The court concluded that Culbertson, although potentially still relevant generally, was not relevant if a taxpayer otherwise qualified as a partner under 704(e) 33 Castle Harbour IV Appeals Court Reverses Again The appeals
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