stating that whether a taxpayer experiences the benefits and burdens of ownership of an asset is a question of fact which must be ascertained from the intent of the parties as evidenced by their written agreements
How later courts described this case
- stating that whether a taxpayer experiences the benefits and burdens of ownership of an asset is a question of fact which must be ascertained from the intent of the parties as evidenced by their written agreements
Written by the judges who cited it.
The opinion
United States Tax Court
166 T.C. No. 1
AVENTIS, INC. AND SUBSIDIARIES,
Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
—————
Docket No. 11832-20. Filed January 28, 2026.
—————
In 2000 P, a domestic corporation; A, P’s French
affiliate; B, an advisor to P; and C, a third-party bank,
entered into a securitization transaction that the parties to
the transaction purported to be a financial asset
securitization investment trust (FASIT) under I.R.C.
§§ 860H through 860L. I.R.C. §§ 860H through 860L were
repealed in 2004, but P’s purported FASIT remained in
place through 2015. FASITs that remained outstanding in
accordance with their original terms on the effective date
of the repeal were exempt from the repeal.
As part of the purported FASIT, A purchased all of
the outstanding shares of a class of preferred stock issued
by P for the sole purpose of representing a regular interest
in the FASIT under I.R.C. § 860L(b)(1). P also issued a
note to B to represent the ownership interest of the FASIT
under I.R.C. § 860L(b)(2), and a note to C to represent
another regular interest.
For each year that the purported FASIT was
outstanding, B, as holder of the ownership interest in the
FASIT, reported the income that P received on the FASIT
assets, and, relying on I.R.C. § 860H(c)(1), deducted
amounts representing the expenses of the FASIT and the
dividends paid to A. After examination of P’s returns for
Served 01/28/26
2
the 2008 through 2011 taxable years, R disregarded the
FASIT because the requirement that all of the interests in
the FASIT be either the ownership interest or a regular
interest was not met, and R allocated income generated by
the FASIT assets in each year to P.
Held: The preferred stock was not a valid regular
interest when the purported FASIT was implemented
because it did not unconditionally entitle A to a specified
principal amount.
Held, further, the preferred stock was not a valid
regular interest when the purported FASIT was
implemented because it did not entitle A to interest
payments based on a fixed or permitted variable rate.
Held, further, regardless of whether the preferred
stock was a valid regular interest at the time the FASIT
was implemented, it would have ceased to be a valid
regular interest in the latter half of 2000 and/or in 2003
because the dividends paid to A ceased to be based on a
fixed or permitted variable rate at those times.
Held, further, P failed to meet the requirements of
the grandfather clause that was enacted when I.R.C.
§§ 860H through 860L were repealed in 2004.
Held, further, P’s failure to strictly comply with
statutory requirements cannot be excused by the
substantial compliance doctrine because they were
essential statutory requirements rather than procedural or
directory regulatory requirements.
Held, further, P has failed to show that it was not
the beneficial owner of the assets.
Held, further, P must recognize the interest income
generated by the FASIT assets.
Held, further, the preferred stock was in substance
equity, and therefore P is not entitled to business interest
deductions in the amounts it paid to A as dividends for each
year in issue.
3
—————
Rajiv Madan, Nathan Wacker, Melinda Gammello, Erin E. Girbach,
Olumayowa S.O. Olujohungbe, and Kevin Stults, for petitioner.
Charles Buxbaum, Matthew Crouch, Andrew Michael Tiktin, Travis
Vance, and Gretchen A. Kindel, for respondent.
KERRIGAN, Judge: Respondent determined the following
deficiencies in petitioner’s federal income tax for its 2008−11 tax years
(years in issue).
Tax Year Deficiency
2008 $10,469,002
2009 9,331,096
2010 9,338,611
2011 9,330,260
Unless otherwise indicated, statutory references are to the
Internal Revenue Code, Title 26 U.S.C. (Code), in effect at all relevant
times, regulation references are to the Code of Federal Regulations, Title
26 (Treas. Reg.), in effect at all relevant times, and Rule references are
to the Tax Court Rules of Practice and Procedure.
The issues for consideration are (1) whether the arrangement
among petitioner, Sanofi-Aventis Amerique du Nord S.A. (SAAN),
Dynamo Investments, Inc. (Dynamo), and Chase Manhattan Bank
(Chase) qualified as a valid financial asset securitization investment
trust (FASIT) under sections 860H to 860L (FASIT rules), (2) if the
arrangement was not a FASIT, whether petitioner substantially
complied with the requirements of the FASIT rules, (3) if the
arrangement was not a FASIT, whether petitioner should be treated as
the beneficial owner of the purported FASIT’s assets, and (4) if the
4
arrangement was not a FASIT, whether the interest in the arrangement
held by SAAN was debt or equity. 1
FINDINGS OF FACT
Petitioner is and was during the years in issue a Pennsylvania
corporation and an indirect subsidiary of its French parent company,
Sanofi, S.A. (Sanofi). 2 Sanofi and its subsidiaries are a multinational
enterprise that specializes in the discovery, development, manufacture,
and commercialization of prescription drugs. Petitioner is and was
during the years in issue the common U.S. parent of an affiliated group
of corporations that carry out Sanofi’s North American operations.
Petitioner filed consolidated federal income tax returns for each year in
issue. Petitioner’s principal place of business was New Jersey when it
filed its Petition.
SAAN and Rhône-Poulenc Investissement, S.A. (RPI), were
French affiliates of petitioner and were also indirect subsidiaries of
Sanofi. On June 20, 2001, the shareholders of RPI approved a name
change to Aventis Investissement S.A. (AI). SAAN was AI’s parent
company, and it dissolved AI without liquidation in 2006. 3
From 2000 to 2011, relevant subsidiaries of petitioner include the
Rorer Group Financial Co., Aventis Pharmaceuticals, Inc. (API), and
Aventis Holdings, Inc. (AHI). Rhône-Poulenc Rorer International
Holdings, Inc. (RPRIH) was a Delaware corporation and an indirect
subsidiary of Sanofi. On December 31, 2001, RPRIH merged into Rhône-
Poulenc Rorer, Inc. (RPR). Before June 20, 2002, petitioner was known
as RPR.
I. Background of the Transaction
Sanofi sought to expand its North American operations in the late
1990s and 2000s and needed liquid financing to accomplish this goal.
Often, petitioner borrowed from its French parent Sanofi in the form of
intercompany loans. As a result of growth in the United States,
petitioner considered funding options, including a FASIT.
1 Other adjustments in the Notice of Deficiency are computational.
2 Before August 20, 2004, Sanofi was known as Rhône-Poulenc, Inc. Between
August 20, 2004, and May 6, 2011, Sanofi was known as Sanofi-Aventis, S.A.
3 Going forward we will refer to RPI and AI as SAAN.
5
In April 1999 Babcock & Brown, Inc. (Babcock & Brown), 4 an
investment banking firm, presented petitioner with a proposal to use a
FASIT to securitize certain intercompany loans. The creation of a
FASIT would allow petitioner to meet its financing needs and obtain tax
benefits on account of differing tax treatment between the United States
and foreign jurisdictions.
FASITs were a statutorily created type of securitization. A
securitization is a financial arrangement where a set of income- or
cashflow-generating assets is pooled and repackaged into securities,
denominated the ownership interest and regular interests, that are sold
to different investors. Under the FASIT rules, valid regular interests of
a FASIT were treated as debt. 5
Babcock & Brown’s original FASIT plan dated April 1999
proposed the use of a security labeled “preferred stock” to be sold to
petitioner’s French affiliate as a regular interest in a FASIT under the
FASIT rules. Babcock & Brown claimed that dividends received on such
preferred stock would be eligible for a “participation exemption” in
European countries, including France and Germany, as well as
deductible to the payor as interest payments on debt under the FASIT
rules. Petitioner paid Babcock & Brown an upfront fee of $970,000 to
implement the FASIT arrangement.
In December 1999 petitioner and BBH Capital, Inc. (BBH), an
affiliate of Babcock & Brown, executed an Asset Management
Agreement (1999 AMA) to govern the proposed FASIT. The terms of the
1999 AMA were never implemented, and the parties finalized the
structure of the transaction at issue in the following year.
4 Babcock & Brown converted from a corporation to a California limited
partnership at some point between the 1999 FASIT proposal and June 12, 2000.
5 Pursuant to section 860H(c)(1), a valid regular interest of a FASIT is
generally treated as debt regardless of its form. See infra Opinion Part I.A.
6
II. The 2000 FASIT Arrangement
A. FASIT Election and Initial Assets
On July 21, 2000, the FASIT 6 was created when RPR, 7 SAAN,
BBH, Chase, and Dynamo, a wholly owned subsidiary of Babcock &
Brown that was created for the purpose of this transaction, entered into
an Amended and Restated Asset Management Agreement (2000 AMA).
The parties to the FASIT arrangement also entered into an Amended
and Restated Note Purchase Agreement to govern the FASIT. In the
2000 AMA, BBH assigned its rights and obligations under the 1999
AMA to Dynamo and Chase and was effectively no longer a party to the
FASIT.
Around this time a presentation was created on petitioner’s
letterhead explaining the arrangement. This document was entitled
Approval of FASIT Transaction. The document provided background
information on FASITs including their tax treatment. It specifically
stated: “In computing net taxable income or loss of the FASIT, payments
on these so-called regular interests are deductible regardless of the
actual form of such regular interests.”
This document used the term “preferred dividends” for the
interest which became the Series A/E Stock. Additionally, the document
explained that petitioner would treat the payment of preferred
dividends as tax-deductible interest, and SAAN under French tax laws
would treat the receipt of preferred dividends as nontaxable dividends.
The approval presentation indicated that there would be savings of
$12 million annually.
The 2000 AMA was only to be modified “by a written instrument
evidencing such amendment and signed by each of the parties hereto.”
If the FASIT arrangement was valid, both SAAN and Chase would hold
regular interests in the FASIT. Dynamo claimed it was the owner of the
FASIT assets for U.S. federal income tax purposes, even though
petitioner managed the FASIT assets and held legal title.
6 We acknowledge that the Commissioner contends that the transaction did
not qualify as a FASIT; and our use of the term to describe the transaction for the
purpose of this Opinion is for clarity and does not have legal effect.
7 Going forward we will refer to RPR as petitioner.
7
Petitioner designated a segregated pool of $571 million in
intercompany loans on its books as the initial FASIT assets. These
initial assets consisted of two debt instruments (short-term and long-
term) that RPR (UK) Holdings, Ltd. (RPRUK), a subsidiary of Sanofi,
issued together with certain associated currency and interest rate swaps
to petitioner.
The short-term portion had a principal of £96 million and accrued
interest at a variable rate equal to the current one-month London
Interbank Offered Rate (LIBOR) plus 25 basis points (Initial Short-
Term Loan). The Initial Short-Term Loan was repayable upon
petitioner’s demand, but no earlier than one year after the loan was
executed.
The initial long-term portion had a principal of £545 million and
accrued interest at a fixed rate of 6.85% (Initial Long-Term Loan). In
1998, £260 million of the Initial Long-Term Loan’s principal was
capitalized and its principal was £285 million as of 2000. The Initial
Long-Term Loan matured on July 1, 2003.
The 2000 AMA limited the type of assets that the asset manager
could choose as FASIT assets and referred to these assets as permitted
assets. The 2000 AMA defined “permitted asset” as:
a financial instrument[], . . . which in each case:
(i) is denominated in United States dollars;
(ii) has a fair market value (FMV) when acquired
that is equal to the face amount thereof and
otherwise does not include any “market
discount” within the meaning of [s]ection
1278(a)(2), “original issue discount” within
the meaning of [s]ection 1273(a)(1), or “bond
premium” within the meaning of [s]ection
171(b);
(iii) is (a) treated as a “variable rate debt
instrument” and bears interest at a qualified
floating rate within the meaning of Treasury
Regulation section 1.1275-5(b) (including a
synthetic debt instrument within the
meaning of Treasury Regulation section
1.1275-6), (b) a fixed rate bank deposit, (c)
shares in a money market fund within the
meaning of Rule 2a-7 under the Investment
8
Company Act of 1940, as amended, or (d) a
fixed rate debt instrument;
(iv) has a yield to maturity when acquired that is
less than the Applicable Federal Rate in effect
for the calendar month in which the asset is
acquired by the Company plus 5 percentage
points;
(v) matures as to principal and interest, or is
redeemable at the option of the holder thereof
at a redemption price equal to the principal
amount thereof plus accrued interest thereon,
on or prior to the last Business Day of the
Initial Term or the then current Renewal
Term [of the FASIT], as applicable; and
(vi) is not issued by [Dynamo or Chase] or any
Affiliate of [Dynamo or Chase] . . . .
Both the short-term and long-term initial assets were permitted
assets pursuant to the 2000 AMA and met the statutory definition of
permitted assets in section 860L(c)(1).
Petitioner issued three FASIT interests to the FASIT investors,
the returns on which were funded by the interest income generated by
the FASIT assets. The three FASIT interests were:
Class I Note issued to Dynamo in exchange for $500,000,
designated the ownership interest; 8
Class II Note issued to Chase Bank in exchange for $11.5 million,
designated a regular interest in the FASIT; 9 and
Series A/E Stock 10 issued to SAAN in exchange for $559,500,000,
designated a regular interest in the FASIT. 11
8 The designation as an ownership interest does not mean that the statutory
requirements have been met.
9 The designation as a regular interest does not mean that the statutory
requirements have been met.
10 Our use of the term “stock” for the purpose of this Opinion is for clarity and
does not have legal effect.
11 The designation as a regular interest does not mean that the statutory
requirements have been met.
9
When RPRIH merged into petitioner in 2001, petitioner had an
unrelated class of outstanding preferred stock it identified as “Series A”
preferred stock. To distinguish the FASIT-issued Series A Stock in
RPRIH from petitioner’s preexisting Series A shares, each share of the
FASIT-issued Series A Stock in RPRIH was converted into a share of
“Series E” stock of petitioner in the merger. For each year in issue, the
stock remained outstanding as Series E Stock in petitioner. We refer to
the 280 shares in petitioner that were issued as part of the transaction
as “Series A/E Stock.”
Dynamo filed a FASIT election with its Form 1120, U.S.
Corporation Income Tax Return, for its taxable year ending March 31,
2001, to treat the FASIT arrangement as a FASIT for U.S. federal
income tax purposes, on July 21, 2000. Dynamo was an eligible
corporation as defined in section 860L(a)(2). The FASIT election
identified each of the Initial Loans and a money market account as the
initial FASIT assets. The initial FASIT assets had an aggregate
principal amount of $571,500,000. Petitioner did not have any collateral
securing either of the Initial Loans.
B. Securities Issued to Interest Holders
The income generated by the FASIT assets was distributed
annually to the Class I Noteholder, the Class II Noteholder, and the
Series A/E Stockholder on December 31 of each year. First, the income
from the FASIT was used to pay the asset manager’s fee. Second, the
income was used to pay the interest due to the Class I and Class II
Noteholders on their respective returns. Third, the remaining income
was eligible to be distributed as dividends to the Series A/E Stockholder.
10
The Class I Noteholder and the Class II Noteholder were both
entitled to receive FASIT Rate Interest and Supplemental Interest each
year. FASIT Rate Interest and Supplemental Interest were calculated
daily. FASIT Rate Interest was calculated as the principal amount of
the Class I or Class II Note multiplied by the “FASIT Rate.” The FASIT
Rate for each day was defined as the amount of interest accrued on that
day by the underlying FASIT assets, less the asset manager’s fee, and
any guaranty fee, divided by the principal amount of the FASIT assets.
Supplemental Interest entitled the Class I and II Noteholders to yearly
interest at a rate of 1.5522% of the principal amount of the respective
Note.
As included in the 2000 AMA and in the Class I Note, Dynamo as
the Class I Noteholder was entitled to Additional Interest, which was an
amount equal to the excess, if any, of (1) the total amount of income
(other than gain) earned on the FASIT assets during such Accrual
Period, less (2) the sum of (i) the amount of FASIT Rate Interest and
Supplemental Interest due under this Note in respect of such Accrual
Period, (ii) the amount of FASIT Rate Interest and Supplemental
Interest (as defined in the Class II Note of the Company) due under the
Class II Note of the Company in respect of such Accrual period, and
(iii) the sum of the amounts for each day during such Accrual Period
equal to (a) the FASIT Rate for each such day minus 0.00033291153
divided by (y) 365 or 366 as appropriate multiplied by (b) the Adjusted
Issue Price of the Series A/E Stock.
Under the 2000 AMA any gain realized from a FASIT asset
during an accrual period would be allocated to the Class I Note. All
determinations of income, gain, loss, or deduction under the transaction
documents were to be made under U.S. federal income tax principles
except where otherwise indicated.
The Additional Interest formula was structured to reflect the
FASIT Rate Interest and Supplemental Interest paid to the Class I
Noteholder and the Class II Noteholder on the principal amount of
$12 million. The Additional Interest formula was designed to compute
to zero, meaning after distribution of the FASIT Rate Interest and
Supplemental Interest, no residual income should have remained from
the FASIT assets to be allocated as Additional Interest. From 2000
through 2011 petitioner calculated the Additional Interest due to
Dynamo to be zero.
11
The terms of the Series A/E Stock were set forth in a Certificate
of Voting Powers, Designations, Preferences, and Restriction (Stock
Certificate). As holder of the Series A/E Stock, SAAN was entitled to
one vote per share on all corporate matters and voted with the holders
of petitioner’s common stock. SAAN was also entitled to elect one
director of petitioner’s board of directors. Petitioner labeled the Series
A/E Stock as preferred stock with signatures from two of its officers.
Additionally, petitioner treated the Series A/E Stock as preferred stock
for book accounting purposes.
If the Series A/E Stock was treated as equity for French tax
purposes, SAAN was entitled to a “participation exemption” for
dividends on such stock and did not pay tax on the amount exempted.
Dividends were payable on the Series A/E Stock at the discretion of
petitioner’s board of directors. The undistributed profits available for
payment on the Series A/E Stock were the earnings on the FASIT assets
less payments of interest due to the Class I Note and the Class II Note,
the asset manager’s fee, any guaranty fee, and any other expense of the
FASIT. Dividends were cumulative, meaning that for each accrual
period, the Series A/E Stockholder accrued the right to receive the
FASIT’s distributable profits for that accrual period regardless of
whether the distributable profits were actually paid out as dividends.
Payments on the Series A/E Stock could not be made from petitioner’s
general corporate assets.
Petitioner’s board of directors declared dividends on the Series
A/E Stock each year from 2000 to 2011, except 2001, in the following
amounts:
12
Year Dividend Amount
2000 $16,342,405
2002 11,314,602
2003 11,997,891
2004 23,673,649
2005 27,814,151
2006 30,019,360
2007 29,999,009
2008 29,904,535
2009 29,615,679
2010 29,639,535
2011 29,613,027
The Stock Certificate included a provision addressing the
redemption of the Series A/E Stock upon termination of the FASIT. The
Series A/E Stock was to be redeemed at a price equal to the fair market
value (FMV) of the FASIT assets less the amounts due on the Notes, and
any other accrued and unpaid expenses of the FASIT, referred to as a
“liquidation preference.”
C. The Money Market Account
The FASIT assets paid interest semiannually. Each year, during
the interim period between the interest payment on the FASIT assets to
petitioner and the yearend payment petitioner made to the FASIT
investors, the interest was deposited and held in a money market
account. This enabled the funds to earn interest before payment to the
FASIT investors. The money market account represented a temporary
investment of earnings of the FASIT arrangement pending distribution.
The interest from the money market account was included in FASIT
earnings. Dynamo reported the earnings from the money market
account as dividend income.
13
From 2000 to 2011, petitioner advised that the money market
account earned dividend income as follows:
Year Dividend Income
2000 $206,981
2001 474,087
2002 94,804
2003 43,022
2004 98,070
2005 260,392
2006 395,921
2007 398,806
2008 223,200
2009 15,408
2010 39,268
2011 12,756
D. Asset Manager
Pursuant to the 2000 AMA and the 2003 AMA, 12 RPRIH and then
petitioner were appointed the asset manager of the FASIT assets. The
asset manager received annual compensation equal to 0.005% of the
FASIT amount, computed daily. The FASIT amount was defined as the
aggregate principal amount of the Class I and II Notes and the
aggregate adjusted issue price of the Series A/E Stock as of any date. In
its capacity as asset manager, petitioner was able to guarantee the
FASIT assets in exchange for an additional fee “to be determined by
[petitioner] in accordance with customary commercial practices.” No
guaranty fees were paid in conjunction with the FASIT arrangement.
There was no separate FASIT entity. At all times the FASIT
existed as a segregated pool of assets on petitioner’s balance sheet.
12 The AMA was updated in 2003 and is addressed infra Findings of Fact Part
III.
14
Petitioner was subject to various restrictions with regard to the FASIT
assets.
Petitioner, as asset manager of the FASIT arrangement, was
required under the AMA to hold the FASIT assets until maturity or
redemption. Additionally, petitioner was authorized to replace any
FASIT asset with any other permitted asset of equal principal amount
so long as the replacement did not result in the realization of gain or loss
to any person for U.S. federal income tax purposes, and provided that
the aggregate principal amount of the FASIT assets was at all times
equal to the FASIT amount. The 2000 AMA prohibited petitioner from
(1) pledging, granting a security interest, assigning as a security, or
otherwise encumbering the FASIT assets; (2) issuing any additional
debt securities on parity with or senior to the Class I and II Notes; or
(3) applying any income received from the FASIT assets in a manner
other than as specified in the 2000 AMA.
Section 5 of the 2000 AMA specified how petitioner was to apply
income generated from the FASIT assets. At the end of each year,
petitioner was required to apply FASIT earnings in the following order:
(1) to payment of the asset manager’s fee, (2) to payment of any guaranty
fee and any other expenses of the FASIT, (3) to payments made on the
Class I Note and the Class II Note, and (4) to the extent petitioner’s
board of directors declared dividends, to payment on the Series A/E
Stock.
In accordance with the AMA, petitioner was required to invest
FASIT earnings not distributed at yearend into additional permitted
assets which would then be considered FASIT assets. Any gain realized
in respect of FASIT assets was to be allocated to the Class I Note and
any loss in respect of FASIT assets was to be allocated to the Series A/E
Stock. No valuation study was ever done to determine the FMV of the
FASIT assets.
III. 2003 and 2005 Changes to the FASIT
On September 30, 2003, petitioner acknowledged receipt of
£289,867,553 from RPRUK as payment in full satisfaction of the Initial
Long-Term Loan. With part of the proceeds, petitioner acquired a new
FASIT asset—a promissory note reflecting a loan from AHI to API, each
a subsidiary of petitioner, with a principal amount of $415,600,000 that
accrued interest at a fixed rate of 5.02% per year (2003 Loan). The 2003
Loan matured on December 29, 2012. The 2003 Loan was secured by
15
certain of API’s receivables pursuant to a security agreement. The
covered amount in the security agreement equaled 110% of the principal
amount of the 2003 loan. The 2003 Loan met both the 2000 AMA
requirements and the statutory requirements for a permitted asset.
With the remaining funds petitioner repaid $400,000 of the
$500,000 principal outstanding on the Class I Note and redeemed the
Class II Note in full. At the outset of the FASIT arrangement, Chase
lent Dynamo $400,000 of the $500,000 purchase price of the Class I
Note. Dynamo used the proceeds from the partial redemption of the
Class I Note to satisfy its obligation to Chase. Upon redemption of the
Class II Note, Chase withdrew from the FASIT entirely.
To reflect Chase’s withdrawal and the accompanying changes to
the FASIT assets, a Second Amended and Restated Asset Management
Agreement (2003 AMA) and a Second Amended and Restated Note
Purchase Agreement were executed on September 30, 2003. The 2000
and 2003 AMAs were generally the same, except for the absence of
Chase. The terms of the Series A/E Stock were not amended and none
of the stock was redeemed as a result of the 2003 changes to the FASIT.
From 2000 through September 30, 2003, when Chase withdrew
from the FASIT arrangement, the Class I Noteholder never received
Additional Interest. After Chase’s withdrawal, the Class I Note was
revised to reflect the reduction in principal from $500,000 to $100,000.
The Class I Note’s Additional Interest provision was not updated to
reflect the reduction of third-party investment to $100,000.
Before and after the 2003 AMA was in effect, Dynamo was
entitled to Additional Interest equal to FASIT income less the sum of
(1) FASIT Rate Interest due on the Note(s), (2) Supplemental Interest
due on the Note(s), and (3) the FASIT Rate minus 0.00033291153
multiplied by the adjusted issue price of the Series A/E Stock. After the
changes to the FASIT assets in 2003, petitioner continued to calculate
the Additional Interest due to Dynamo as zero.
On July 1, 2005, the remaining initial asset, RPRUK’s Short-
Term Loan of £102,914,946 ($144 million), was repaid. Petitioner used
the proceeds from the repayment of the Initial Short-Term Loan to
purchase an additional account receivable from AHI to API in the
amount of $144 million (2005 Loan) that matured on March 31, 2015.
Consequently, as of July 1, 2005, the FASIT held two intercompany
receivables due from API. The 2005 Loan accrued interest annually at
16
a fixed rate of 5.81%. The 2005 Loan met the definition of a permitted
asset as defined in the 2000 AMA and the statutory requirements of a
permitted asset. By a separate security agreement, API’s receivables
similarly secured up to 110% of the principal amount of the 2005 Loan.
IV. 2005 Renewal and Subsequent Renewals of the FASIT
Under the terms of the 2000 and 2003 AMAs, the FASIT was set
to terminate on January 15, 2005, unless the parties to the FASIT
arrangement mutually agreed to extend the arrangement for another
five-year term. The FASIT arrangement could be extended in five-year
increments with the total term not to exceed 30 years. Each party was
required to notify the other parties in writing of its intention to extend
the FASIT by October 15 of the year before the end of each term. By
letter agreement dated January 14, 2005, the parties mutually agreed
to extend the FASIT for a second five-year term ending January 15,
2010. None of the parties provided renewal notice in accordance with
the 2003 AMA by October 15 of the year before termination (2004).
Instead the parties agreed to waive the 90-day notice requirement in the
letter agreement dated January 14, 2005.
Leading up to the 2010 renewal of the FASIT, Babcock & Brown
became insolvent. To ensure Dynamo’s financial wellbeing through a
third five-year term, petitioner sought to have Dynamo sold to a third
party.
On January 15, 2010—the same day petitioner, SAAN, and
Dynamo agreed to renew the FASIT for its third five-year term—
petitioner’s affiliate Sanofi-Aventis, U.S., Inc., entered into an
agreement with Babcock & Brown (put option agreement). The put
option agreement granted Babcock & Brown an option to sell all of the
Dynamo shares to Sanofi-Aventis, U.S., Inc. subject to certain
conditions. The put option agreement granted Sanofi-Aventis, U.S., Inc.
and API the right to designate any other entity described by petitioner’s
officers as a “friendly” partner, as purchaser of the Dynamo shares
under the agreement. Petitioner paid Babcock & Brown $2,275,000 in
exchange for renewing the FASIT and the rights granted in the put
option agreement. Around July 2010 Chase acquired Dynamo.
V. Termination of the FASIT
The parties to the FASIT arrangement did not extend it in 2015
for a fourth five-year term. Instead of extension, the parties adopted a
plan of liquidation to unwind the FASIT effective January 15, 2015. The
17
FASIT arrangement terminated in April 2015. Under the plan of
liquidation, petitioner was required, within 90 days, to liquidate the
FASIT assets, pay the expenses of the FASIT, and use the remaining
proceeds to redeem the Class I Note and the Series A/E Stock. The
redemption price of the Series A/E Stock was equal to the aggregate
“liquidation preference” as of such date.
VI. Tax Reporting and Determination of Deficiency
Under the 2000 and 2003 AMAs, petitioner was required to treat
Dynamo as the owner of the FASIT assets for U.S. tax purposes.
Accordingly, Dynamo included on its federal income tax returns the
income received on the FASIT assets and deducted payments made on
the Class II Note while it was outstanding, dividends paid on the Series
A/E Stock, and the asset manager’s fee. For years 2008 through 2010
Dynamo reported earnings from the money market account as dividend
income on its tax returns. For years 2010 through 2012, after Chase
acquired Dynamo, Chase reported Dynamo’s interest income on the
Class I Note and the FASIT’s income and expenses as part of its
consolidated group.
Petitioner filed consolidated Forms 1120 for each year in issue.
Petitioner reported the Series A/E Stock as “preferred stock” on its
Schedule L, Balance Sheets per Books, for each year in issue. On the
Schedules M–2, Analysis of Unappropriated Retained Earnings per
Books, attached to its Forms 1120 for each year in issue, petitioner
reported various amounts of “Other decreases.” Part of the “Other
decreases” for each year was a “FASIT Asset Retained Earnings
Adjustment” in the following amounts: $29,901,427, $29,617,411,
$29,637,801, and $29,614,577 for 2008, 2009, 2010, and 2011,
respectively. These numbers reflect amounts received as interest on
FASIT assets and as payments due on the Class I Note and dividends
declared on the Series A/E Stock.
After examination respondent disregarded Dynamo’s FASIT
election and designation as owner of the FASIT assets for tax purposes.
Respondent allocated the income generated by the FASIT assets less the
interest paid to Dynamo, asset manager’s fees, and FASIT expenses to
petitioner.
VII. Summary of Expert Witnesses
Various witnesses gave testimony relevant to the FASIT
arrangement and to the substantive terms of the Series A/E Stock.
18
Among those witnesses were the following experts, whose reports will
be discussed further throughout this Opinion.
A. Petitioner’s Expert, Michael Cragg
Petitioner offered expert testimony from Michael Cragg, a senior
partner at a global economic consulting firm with a Ph.D. in economics.
Dr. Cragg has over 25 years of experience analyzing financial markets
and the public financial services sector for the purposes of research,
advising, and testifying. Dr. Cragg concluded that the Series A/E Stock
was more similar to debt than to equity and that the FASIT
arrangement did not cause an economic loss to the U.S. Treasury.
B. Respondent’s Experts
1. Evan Cohen
Respondent offered expert testimony from Evan Cohen, the
principal and chairman of an economic consulting firm based in Boston,
Massachusetts. Mr. Cohen has a master’s degree in business
administration with a concentration in financial engineering. He
received his Chartered Financial Analyst designation from the
Chartered Financial Analyst Institute in 2013. Mr. Cohen has over 25
years of experience in capital structure, corporate finance, and
economics.
Mr. Cohen’s opinion concluded from a financial and economic
perspective that petitioner did not make an economic commitment to
return a predictable, pre-specified amount of capital to the Series A/E
Stockholder. He also concluded that petitioner did not make an
economic commitment to make predictable, pre-specified dividend
payments to the Series A/E Stockholder and that petitioner’s
commitment to make dividend payments was not consistent with debt
instruments. Additionally, he concluded that there was not sufficient
information for the Series A/E Stockholder to assess the risk of the
Series A/E Stock while the instrument was outstanding.
2. Nasser Ahmad
Respondent offered expert testimony from Nasser Ahmad, the
managing partner and chief investment officer of an asset management
firm based in New York, NY. Mr. Ahmad has a master’s degree in
electrical engineering and computer science and has acquired over 30
years of experience in the financial services industry since completing
19
his education. In particular, Mr. Ahmad has extensive experience
analyzing and trading fixed income securities, structured and
securitized debt, and public and private equity.
Mr. Ahmad concluded that the Series A/E Stock was structured
as equity, with characteristics that align with typical equity features.
Additionally, he concluded that market participants acting in an arm’s-
length manner would have recognized and treated the Series A/E Stock
as equity. His testimony also addressed the allocation of cashflows
pertaining to the money market account following Chase’s withdrawal
from the arrangement and whether this allocation would be expected in
an arm’s-length transaction.
OPINION
We must first decide whether the FASIT arrangement was a valid
FASIT pursuant to the statutory requirements. If the FASIT was not
valid, we consider the following: (1) whether there was substantial
compliance, (2) whether petitioner was the beneficial owner of the
FASIT assets, and (3) whether the Series A/E Stock should be treated
as debt for federal income tax purposes. Petitioner contends that the
FASIT arrangement was valid for the years in issue. In contrast
respondent contends that the FASIT arrangement was invalid from its
inception in 2000.
Respondent determined that petitioner was required to recognize
interest income on the assets identified in the FASIT arrangement for
the years in issue. Generally, the Commissioner’s determinations in a
Notice of Deficiency are presumed correct, and the taxpayer bears the
burden of proving those determinations are erroneous. See Rule 142(a);
Welch v. Helvering, 290 U.S. 111, 115 (1933). Petitioner does not
contend that the burden of proof shifts to respondent under section
7491(a) as to any issue of fact.
Respondent in support of his argument that the FASIT
arrangement was not a valid arrangement offered Exhibit 314-R,
Revenue Agent Lynch’s notes from her interview with Clifford Losh held
on October 24, 2013. At trial Exhibit 314-R was admitted as a business
record. Ruling on whether the notes can be admitted as nonhearsay was
reserved. Both Ms. Lynch and Mr. Losh testified during the trial. The
issue of whether the document is an exception to hearsay does not need
to be decided as the notes are not relevant. Accordingly, Exhibit 314-R
is not admitted for any additional purpose. See Fed. R. Evid. 403.
20
I. Overview of FASITs
Statutorily created FASITs were a type of securitization, which is
the process of pooling assets into a fund or entity and selling securities
backed by the specified pool of assets. Generally, income generated by
the securitized assets funded interest and principal payments made to
the holders of the securities.
A. The FASIT Rules
The FASIT rules were enacted pursuant to section 1621(a) of the
Small Business Job Protection Act of 1996, Pub. L. No. 104-188, 110
Stat. 1755, 1858. The purpose of the statutorily created FASIT was to
permit the securitization of pools of nonmortgage debt obligations held
by financial institutions in order to
spread the risk of credit on the debt to others. The [Senate
Finance] Committee believe[d] that the spreading of credit
risk will lessen the concentration of such risk in banks and
other financial intermediaries which, in turn, will lessen
the pressure on Federal deposit insurance. Further, the
Committee believe[d] that the spreading of credit risk
through securitization will result in lower interest rates for
consumers.
S. Rep. No. 104-281, at 126 (1996), reprinted in 1996 U.S.C.C.A.N. 1474,
1600.
The FASIT rules of section 860L(a)(1) set forth five statutory
requirements for FASIT qualification:
(1) In general.—For purposes of this title, the terms
“financial asset securitization investment trust” and
“FASIT” mean any entity—
(A) for which an election to be treated as a
FASIT applies for the taxable year,
(B) all of the interests in which are regular
interests or the ownership interest,
(C) which has only one ownership interest and
such ownership interest is held directly by an
eligible corporation,
(D) as of the close of the third month
beginning after the day of its formation and at all
times thereafter, substantially all of the assets of
21
which (including assets treated as held by the entity
under section 860I(b)(2)) consist of permitted assets,
and
(E) which is not [a regulated investment
company] described in section 851(a).
Subject to exceptions not relevant here, domestic subchapter C
corporations were “eligible corporations” that could hold the ownership
interest of a FASIT. § 860L(a)(2). Section 860L(c)(1) defines permitted
assets as:
(1) In general.—The term ‘permitted asset’ means—
(A) cash or cash equivalents,
(B) any debt instrument (as defined in section
1275(a)(1)) under which interest payments (or other
similar amounts), if any, at or before maturity meet
the requirements applicable under clause (i) or (ii) of
section 860G(a)(1)(B),
(C) foreclosure property,
(D) any asset—
(i) which is an interest rate or foreign
currency notional principal contract, letter of
credit, insurance, guarantee against payment
defaults, or other similar instrument
permitted by the Secretary, and
(ii) which is reasonably required to
guarantee or hedge against the FASIT's risks
associated with being the obligor on interests
issued by the FASIT,
(E) contract rights to acquire debt
instruments described in subparagraph (B) or assets
described in subparagraph (D),
(F) any regular interest in another FASIT,
and
(G) any regular interest in a REMIC.
When considered together, the FASIT rules’ requirements
demonstrate that FASITs were a method of securitization intended to
pass the economic exposure to underlying debt instruments through the
FASIT entity to investors. In accordance with this objective, a valid
regular interest in a FASIT is treated as debt for federal income tax
purposes regardless of how it would be classified by other standards of
law. § 860H(c)(1).
22
B. Repeal of the FASIT Rules
The FASIT rules were repealed by section 835(a) of the American
Jobs Creation Act of 2004 (AJCA), Pub. L. No. 108-357, 118 Stat. 1418,
1593. The House Committee on Ways and Means stated that “FASITs
are not being used widely in the manner envisioned by the Congress” as
a reason for the repeal. H.R. Rep. No. 108-548, pt. 1, at 291 (2004).
Specifically, the Committee noted that FASITs are “particularly prone
to abuse and are likely being used primarily to facilitate tax avoidance
transactions” and further stated that the Committee was aware that
FASITs were being used “to facilitate the issuance of certain tax-
advantaged cross-border hybrid instruments that are treated as
indebtedness in the United States but equity in the foreign country of
the holder of the instruments” and that was not the intention when
Congress enacted the FASIT rules. Id. at 291 & n.325.
The repeal of the FASIT rules was effective January 1, 2005,
except for those FASITs “in existence on [October 22, 2004] to the extent
that regular interests issued by the FASIT before such date continue to
remain outstanding in accordance with the original terms of issuance.”
AJCA § 835(c) (grandfather provision), 118 Stat. at 1594. For the FASIT
arrangement to be valid for the years in issue, the arrangement must be
valid, at all times, from its inception and at all times before 2008, which
includes meeting the requirements of the grandfather provision.
II. Analysis of FASIT Arrangement Validity
In the Notice of Deficiency, respondent determined that the
FASIT arrangement was not a valid FASIT at all times before the
effective date of the grandfather provision, for two reasons. First,
respondent argues that the Series A/E Stock did not meet the
requirements of a valid regular interest of a FASIT at three specific
times: (1) from inception, (2) in the latter half of 2000 because of the
allocation of income earned by the money market account, and (3) in the
latter half of 2003 because of Chase’s withdrawal from the arrangement.
Second, respondent argues that when the parties altered the terms of
the FASIT when they renewed the FASIT by letter agreement on
January 14, 2005, the extension had no effect because the FASIT had
terminated on its own.
23
A. The Series A/E Stock Was Not a Valid Regular Interest
from the Arrangement’s Inception.
A valid FASIT must meet five statutory requirements. See
§ 860L(a)(1). The FASIT arrangement at issue failed to meet the
requirement that all interests were regular interests or the ownership
interest.
1. Requirements of a Regular Interest in a FASIT
A regular interest in a FASIT was any interest issued by the
FASIT on or after the startup date that was designated a regular
interest, had fixed terms, and satisfied the following five requirements:
(i) such interest unconditionally entitles the holder
to receive a specified principal amount (or other similar
amount),
(ii) interest payments (or other similar amounts), if
any, with respect to such interest are determined based on
a fixed rate, or, except as otherwise provided by the
Secretary, at a variable rate permitted under section
860G(a)(1)(B)(i),
(iii) such interest does not have a stated maturity
(including options to renew) greater than 30 years (or such
longer period as may be permitted by regulations),
(iv) the issue price of such interest does not exceed
125 percent of its stated principal amount, and
(v) the yield to maturity on such interest is less than
the sum determined under section 163(i)(1)(B) with respect
to such interest.
§ 860L(b)(1)(A).
With respect to the Series A/E Stock’s classification as a regular
interest, respondent challenges its satisfaction of the first two
requirements: (i) such interest unconditionally entitles the holder to
receive a specified principal amount (or other similar amount), and (ii)
interest payments (or other similar amounts), if any, with respect to the
24
stock were based on a fixed rate, or, except as otherwise provided by the
Secretary, at a variable rate permitted under section 860G(a)(1)(B)(i). 13
2. Lack of an Unconditional Return of a Prespecified
Principal Amount on Series A/E Stock
The Series A/E Stock had no principal amount, and its terms were
described by the Stock Certificate instead of a note purchase agreement
or a promissory note. The Stock Certificate provided that the Series A/E
Stock’s original issue price was $1,998,214 per share. To satisfy the
requirement that a regular interest unconditionally return a pre-
specified principal amount under section 860L(b)(1)(A)(i), the Series A/E
Stock should have unconditionally entitled SAAN to receive $1,998,214
per share or a specified amount upon redemption or liquidation of the
FASIT.
Respondent argues that the liquidation preference did not entitle
the Series A/E Stockholder to any specified amount and therefore did
not satisfy the return of principal requirement. Petitioner argues the
liquidation preference was structured in a manner that entitled the
Series A/E Stockholder to receive the original issue price of $1,998,214,
or $559,500,000 in total, upon liquidation or redemption of the stock
under any circumstance. We agree with respondent.
The Series A/E Stock entitled its holder to receive upon
liquidation or redemption of the stock an amount limited to the
liquidation preference. The Series A/E Stock’s liquidation preference
was contingent on both the FMV of the FASIT assets at the time of
liquidation and the fees and expenses incurred in managing the FASIT
assets. Respondent’s expert Mr. Ahmad explained that the liquidation
preference effectively subordinated the payments due to the Series A/E
Stockholder upon liquidation to those payments due to the Class I and
II Noteholders. According to his report the Series A/E Stockholder was
the “last in line” to get paid because there was no other investor in this
securitization that was subordinate to the Series A/E Stockholder. The
Series A/E Stockholder would receive the balance after all other claims
are made.
13 Section 860G and the accompanying regulations provide rules applicable to
Real Estate Mortgage Investment Conduits (REMICs), another type of securitization
of debt obligations. As is the case here, the FASIT rules incorporated by reference
many rules applicable to REMICs.
25
The FASIT arrangement did not provide the Series A/E Stock
with a specified principal or similar amount because the liquidation
preference was tied to the FMV of the FASIT assets. The FMV of an
asset is the price at which the property would change hands between a
willing buyer and a willing seller, neither being under any compulsion
to buy or sell, and both having reasonable knowledge of the relevant
facts. United States v. Cartwright, 411 U.S. 546, 551 (1973). The
liquidation preference directly correlated with the FMV of the FASIT
assets because the Series A/E Stock was entitled only to payment from
the FASIT assets and not petitioner’s general assets.
Respondent relied upon the expert testimony of Mr. Cohen to
explain why the FMV of the FASIT assets could vary over time, meaning
the liquidation preference could vary. Fixed rate debt instruments can
vary over their life, as the fixed rate of return becomes more or less
favorable relative to other available instruments. This results in the
FMV of fixed rate assets varying with changes in market rates.
Mr. Cohen further explained that petitioner did not take steps to
protect the Series A/E Stockholder from FMV variation. To be
consistent with the AMAs petitioner should have managed the FASIT
assets to ensure that they would mature at the time of redemption.
Petitioner included assets in the FASIT pool that were not set to expire
at the end of the current term of the FASIT.
Mr. Cohen also explained that the Series A/E Stockholder bore
the risk of FMV variations caused by the issuer’s change in credit risk.
If the financial condition of a borrower declines, the risk of default
increases and the FMV of the debt also declines. The inverse is also true
and the FMV of the debt increases if the financial condition of the
borrower improves.
According to Mr. Cohen, if FASIT assets were liquidated before
the end of the AMA or if they were not scheduled to mature before the
end of the current five-year term, the FMV of the FASIT assets would
vary with changes in the underlying issuer’s credit quality. The Series
A/E Stockolder bore this risk that more or less than the full capital
contribution of the Series A/E Stock could be returned.
Security agreements mitigated the credit risk the FASIT was
exposed to with respect to the 2003 and 2005 Loans. Rather than
repayment of the loans depending on API’s creditworthiness, the
security agreements merely shifted the FASIT’s risk to that of the ability
26
of API’s creditors to fulfill the receivables. Therefore, the FASIT was at
all times subject to some level of credit risk that could have negatively
affected the FMV of the FASIT assets.
Further, variation of the expenses of the FASIT could have
negatively affected the value of the liquidation preference. One
potential expense was petitioner’s option to guarantee the value of the
FASIT assets. The AMAs gave petitioner discretion to, at any time,
provide a guaranty on the value of the FASIT assets in exchange for a
periodic guaranty fee at a rate “to be determined by [petitioner] in
accordance with customary commercial practices.” Even though
petitioner never offered a guaranty on the value of the FASIT assets, its
option to do so throughout the tenure of the FASIT at an unspecified
rate could have negatively affected the value of the liquidation
preference. This effect could have resulted in the Series A/E
Stockholder’s receiving less at liquidation than expected at the outset of
the transaction.
If the FMV of the FASIT assets had declined below the aggregate
original issue price of the Series A/E Stock at the time of calculation of
the liquidation preference, petitioner was not obligated to pay the lost
value to the Series A/E Stockholder. Consequently, the Series A/E
Stockholder would bear any reduction in the FMV of the FASIT asset or
increase in FASIT expenses. The liquidation preference therefore could
not have unconditionally entitled the Series A/E Stockholder to receive
the original issue price of $1,998,214 per share or a specified amount.
3. Whether the Series A/E Stock Entitled Its Holder to
Payments Based on a Fixed Rate, or a Permitted
Variable Rate, Such as a Weighted Average Rate
The Series A/E Stock failed to comply with the FASIT rules’
requirements governing periodic payments to its regular interest
holders. §§ 860L(b)(1)(A)(ii), 860G(a)(1)(B)(i). Treasury Regulation
§ 1.860G-1(a)(3)(i) and (ii) provides that a permissible variable rate
includes a rate based on a current interest rate (a qualified floating
interest rate) or a weighted average rate. An interest rate is a qualified
floating rate “if variations in the value of the rate can reasonably be
expected to measure contemporaneous variations in the cost of newly
borrowed funds in the currency in which the debt instrument is
denominated.” Treas. Reg. § 1.1275-5(b)(1). A rate that correlates with
a benchmark interest rate, such as the federal funds rate or LIBOR, is
considered a qualified floating rate and thus a permitted variable rate.
27
The regulations clarify that certain modifications to floating interest
rates are permissible; relevantly: “A rate is a variable rate if it is— . . .
(B) [e]xpressed as a constant number of basis points more or less than a
rate described in [Treas. Reg. § 1.860G-1(a)(3)(i) or (ii)] . . . .” Treas. Reg.
§ 1.860G-1(a)(3)(iii)(B).
A variable rate could be a qualified floating rate or a rate based
on a weighted average of the interest rates on some or all of the assets
held by the FASIT. Id. subpara. (3). A weighted average interest rate
is generally “a rate that, if applied to the aggregate outstanding
principal balance of a pool of mortgage loans for an accrual period,
produces an amount of interest that equals the sum of the interest
payable on the pooled loans for that accrual period.” Id. subdiv. (ii).
“[A]n interest rate is considered to be based on a weighted average rate
even if, in determining that rate, the interest rate on some or all of the
qualified mortgages is first subject to a cap or a floor, or is first reduced
by a number of basis points or a fixed percentage.” Id. subdiv. (ii)(B).
The maximum amount payable to the Series A/E Stockholder was
the FASIT earnings less interest paid on the Class I and Class II Notes
and accrued expenses. The dividend of the Series A/E Stock could vary
depending on whether the FASIT decided to pay the appropriate
interest, including Additional Interest due to the Noteholders.
The Stock Certificate did not include provisions that would
require payments based on a weighted rate or any other rate to the
Series A/E Stockholder. Instead, the Stock Certificate authorized
petitioner’s board of directors to declare dividends on the stock at its
discretion and subject to the terms set forth in the Stock Certificate. The
amounts of such dividends were not calculated using a fixed rate.
Dividends were cumulative, meaning that if petitioner’s board did not
declare a dividend on the Series A/E Stock for a given year, the Series
A/E Stockholder still became entitled to the FASIT’s distributable
profits for that year. The Series A/E Stockholder was not entitled to
payment of any specified amounts.
Petitioner argues that the lack of a specified rate is not
detrimental because the liquidation preference was structured to ensure
that throughout the life of the FASIT, the Series A/E Stockholder would
effectively receive interest payments determined by the FASIT Rate
minus 3.3 basis points, which it argues is a weighted average rate. This
argument relies on the premise that any distributable profits of the
FASIT that were not distributed increased the liquidation preference of
28
the stock because such unpaid dividends were required to be reinvested
into a FASIT asset. Petitioner contends that even with dividends on the
Series A/E Stock being at the discretion of petitioner’s board of directors,
the Series A/E Stockholder would receive a weighted average rate over
the life of the FASIT by virtue of any dividends actually paid plus the
liquidation preference.
Petitioner’s argument fails because both the timing and the
amounts of dividends were ultimately at the discretion of petitioner’s
board of directors. The Series A/E Stockholder had no mechanism to
enforce declaration of a dividend. Accordingly, the Series A/E Stock does
not meet the requirements for a regular interest under section
860L(b)(1)(A)(ii).
4. Conclusion
The Series A/E Stock did not satisfy the following two
requirements of a regular interest, that it (i) entitled the holder to a
specified principal amount or other similar amount upon termination
and (ii) entitled the holder to payments on a fixed rate per a permitted
variable rate. Accordingly, the FASIT arrangement was not a valid
FASIT from its inception. See § 860L(a)(1)(B).
B. Other Instances Also Resulted in the Arrangement’s Not
Being a FASIT.
As discussed above, we concluded that the arrangement was not
a valid FASIT from its inception. Even if we concluded the opposite,
several instances resulted in the arrangement’s no longer being a
FASIT. Respondent contends that the following resulted in the
arrangement’s not being a valid FASIT: (1) when in the latter half of
2000 the Series A/E Stockholder received interest generated from a
money market account exceeding a weighted interest rate; (2) when,
after Chase’s withdrawal from the arrangement in 2003, petitioner paid
funds to SAAN that should have been paid to Dynamo; and (3) when the
parties changed the terms of the FASIT.
1. Effect of Money Market Income on the Series A/E
Stock’s Status as a Regular Interest
Beginning in the latter half of 2000 and continuing throughout
the life of the arrangement, petitioner invested income earned on the
FASIT assets in a money market account. The investment in the money
market account increased the FASIT income, resulting in an increase of
29
the principal amount of FASIT assets, increasing the Additional Interest
owed to Dynamo.
Petitioner identified the money market account as a FASIT asset,
and treated the income generated by it as FASIT income. Petitioner,
however, did not treat the amounts deposited into the money market
account as increasing the principal of the FASIT assets for the purpose
of determining FASIT Rate Interest.
Petitioner contends that the money market account was a
separate mechanism to keep the deposited funds generating income
before they were paid out to FASIT investors and that the money market
account was not intended to be considered a FASIT asset for the purpose
of calculating Additional Interest. Additionally, petitioner argues that
even if the funds deposited into the money market account increase the
principal amount of the FASIT, its pro rata payment of the money
market interest was consistent with the permitted variable rate
requirement.
The 2000 and 2003 AMAs did not explicitly address how income
from the money market account would be treated by the FASIT;
however, they provided guidance. Under the terms of the 2000 and 2003
AMAs, the FASIT Rate was determined in order to calculate the
Additional Interest. The FASIT Rate was calculated using FASIT
income net of fees in the numerator and the principal amount of the
FASIT assets as the denominator. As the denominator figure increases,
the resulting FASIT Rate decreases. For example, if two pools of assets
produce the same amount of income, the pool with the higher principal
amount of underlying assets boasts a lower rate of return.
Respondent’s expert Mr. Ahmad explained that petitioner
intended that Additional Interest always equal zero. Because FASIT
Rate Interest due to the Noteholders was a function of the asset
manager’s fee and other FASIT expenses, Additional Interest
calculations were a function of each of those items. The 0.00033291153
number in the third step of calculating Additional Interest was used
with the intent that Additional Interest would always be zero. This
calculation was true as long as (1) the aggregate principal of FASIT
assets was equal to the aggregate principal of the Class I Note, Class II
Note, and Series A/E Stock and (2) Supplemental Interest for the year
was equal to $186,264, which is the amount of Supplemental Interest
calculated assuming $12 million of principal on the Class I and Class II
Notes.
30
Petitioner contends that the money market account income was
incorporated into the FASIT Rate as a means of distributing the yield
on each interest holder’s interest in the FASIT arrangement.
Respondent’s expert Mr. Ahmad explained that there were three
possible scenarios for how the money market income was allocated. The
first is a pro rata scenario in which the money market income would be
included in the numerator of the FASIT Rate, but the money market
account principal is not included in the FASIT assets in the
denominator. The second is a principal scenario in which the money
market income would be included in the numerator and the money
market principal income would be included in the denominator. The
third is a gain scenario in which the money market income would be
treated as gain entirely allocable to the Class I Note and would be
excluded from the FASIT Rate computation.
Petitioner used an approach similar to the pro rata scenario.
Because the money market account principal was not included in the
denominator of the computation of the FASIT Rate, the FASIT Rate
Interest increased and Additional Interest was reduced by the same
amount. Mr. Ahmad explained that the pro rata approach resulted in
an excess allocation to the Series A/E Stockholder and the Class II
Noteholder.
Both the principal scenario and the gain scenario are similar to
the terms of the 2000 and 2003 AMAs. The principal scenario follows
the FASIT Rate in the AMAs because the money market interest is
included in earned income of the FASIT and money market principal is
included in the FASIT assets. The gain scenario follows the AMAs
because gain allocated to the FASIT assets should be allocated to the
Class I Noteholder.
Petitioner’s use of a pro rata approach resulted in the Series A/E
Stock’s receiving more of the earnings from the money market account.
This allocation of FASIT income deviated from the transaction
documents, resulting in the Series A/E Stock’s receiving more interest
than the weighted average. Since the Series A/E Stock did not receive
dividends based on a weighted average, the Series A/E Stockholder did
not hold a qualified regular interest, resulting in the FASIT
arrangement’s being invalid. See § 860L(b)(1)(A)(ii); Treas. Reg.
§ 1.860G-1(a)(3)(ii)(B).
31
2. Effect of Chase’s Withdrawal on the Series A/E
Stock’s Status as a Regular Interest
Following Chase’s withdrawal from the FASIT and repayment of
the Class II Note in 2003, petitioner and Dynamo executed the 2003
AMA to reflect Chase’s withdrawal. The principal amount of Dynamo’s
Class I Note was reduced from $500,000 to $100,000. The terms
governing the allocation of FASIT income, including the calculation of
FASIT Rate Interest, Supplemental Interest, and Additional Interest
were left unchanged. Dynamo did not file a new or updated FASIT
election reflecting the revised structure of the FASIT. Dynamo
continued claiming an expense for “Interest on Senior FASIT Regular
Interest,” but in a lower amount than in prior years.
Respondent argues that the failure to update, and the consequent
deviation from the terms of the governing documents, caused the Series
A/E Stockholder to accrue interest payments or other similar amounts
at a rate higher than a permitted variable rate. Petitioner contends that
the failure to update the basis point adjustment component of the
Additional Interest formula was a scrivener’s error. It further contends
that the Series A/E Stockholder was still paid on the basis of a weighted
average rate, and that any deviation was a permissible modification to
a weighted average rate under the regulations.
Respondent’s expert Mr. Ahmad described petitioner’s position
regarding its basis point adjustment from 0.0003291153 to 0.000002774
to ensure that the Additional Interest would always be zero as
“modification by conduct.” This change to the basis point component of
the Additional Interest formula was not made in writing. Before Chase
withdrew and Dynamo reduced its exposure, Additional Interest would
calculate to zero as long as total Supplemental Interest was $186,264.
When the total Supplemental Interest due to the parties decreased to
$1,552, the remaining $184,712 was Additional Interest owed to
Dynamo according to the formula in the Class I Note.
Petitioner made distributions as if the Additional Interest
provision had been updated. Mr. Ahmad explained the effects of
petitioner’s allocation of income from the underlying assets to Dynamo
and the Series A/E Stockholder. The income was allocated as if the
Additional Interest formula had been updated. When calculating the
Additional Interest rate with a basis modification of 0.000002774, the
remaining $184,712 surplus that flowed yearly to the Series A/E
32
Stockholder should instead have been paid to the holder of the Class I
Note.
The increase in return to the Series A/E Stockholder was not a
permitted modification to a weighted average rate and resulted in
dividends being paid on the Series A/E Stock that were not based on a
weighted average rate. Thus, even if the Series A/E Stock had
previously been a valid regular interest, it would have ceased to be one
upon the withdrawal of Chase from the arrangement in 2003.
3. Changes to the FASIT Arrangement Before January
1, 2005
The grandfather provisions of the FASIT regime provide that the
repeal of the FASIT rules does not apply to a FASIT in existence on
October 22, 2004, if the regular interests issued by the FASIT remain
outstanding in accordance with the original terms of issuance. AJCA
§ 835(c)(2). Under the 2000 and 2003 AMAs, the FASIT would
terminate on January 15, 2005, and the Class I and II Notes and the
Series A/E Stock would be redeemed on the same day. The AMAs
included a provision for a five-year extension of the FASIT and a
provision requiring written notice of extension of the FASIT. The notice
of extension was due by October 15, 2004.
The parties did not provide notice of their decision to extend the
FASIT by October 15, 2004. On January 14, 2005, the parties agreed to
extend the FASIT for five years and to waive the 90-day renewal
requirement. The modification to waive the 90-day renewal notice
resulted in a modification of the regular interests issued before October
22, 2004, because the regular interests were no longer outstanding in
accordance with their original terms.
Petitioner contends that the FASIT arrangement met the
requirements of the grandfather clause. The AMAs provided that the
FASIT could be extended only in writing. The waiver of the 90-day
renewal notice was not in accordance with the AMA. Since the
requirements of the AMA were not met, the Series A/E Stock did not
meet the regular interest requirement. The waiver and extension of the
FASIT has no legal effect because the FASIT terminated by its own
terms.
Additionally, petitioner argues that prior deviations from the
contract previously discussed do not violate the grandfather clause
requirement that the regular interests continue to remain outstanding
33
in accordance with their original terms and that the redemption of the
Class II Note did not cause the arrangement to fail to meet the
grandfather clause requirements. We disagree.
The Series A/E Stock received Additional Interest from the money
market income that was not computed as provided for in the AMA and
the formula in the Class I Note. After September 30, 2003, the Series
A/E Stock received amounts that originally were to be paid to the Class I
and Class II Noteholders as Supplemental Interest because the formulas
relating to Supplemental Interest did not take into account the
termination of the Class II Note upon Chase’s withdrawal from the
FASIT and the reduction in principal of the Class I Note from $500,000
to $100,000. In both of these instances, which are discussed in more
detail supra Opinion Part II.B.2, there was a modification of regular
interests.
These modifications result in a failure to meet the requirement of
the grandfather clause because the regular interests did not remain
outstanding with the original terms of issuance. The original terms of
the AMA, the Class I Note, and the Class II Note were modified.
4. Conclusion
We conclude that even if the FASIT arrangement was valid from
its inception, it ceased to be a valid FASIT at two other points: (1) in the
latter half of 2000 because of the allocation of income earned by the
money market account and (2) in the latter half of 2003 because of
Chase’s withdrawal from the arrangement. Additionally, petitioner has
failed to meet the requirements of the grandfather clause.
III. Petitioner’s Substantial Compliance Argument
Petitioner argues alternatively that if the Court agrees with
respondent that the FASIT arrangement did not comply with all of the
FASIT rules, the arrangement should still be treated as a FASIT
because petitioner substantially complied with the FASIT rules and
“any minor ‘errors’ do not deprive the FASIT arrangement of its FASIT
status.” As discussed supra Opinion Part II.A, we conclude that the
FASIT arrangement was not a valid arrangement from its inception.
Petitioner argues that it took all reasonable steps to, and
intended to, comply with the FASIT statutory requirements and the
accompanying regulations. Respondent argues that the substantial
compliance doctrine does not apply and that it is a “narrow equitable
34
doctrine.” See Samueli v. Commissioner, 132 T.C. 336, 345 (2009).
Respondent does not dispute that petitioner intended to enter into a
FASIT in 2000.
When there is a failure to comply with the essential requirements
of the governing statute, no defense of substantial compliance is
available. Estate of Clause v. Commissioner, 122 T.C. 115, 122 (2004).
When requirements relate “to the substance or essence of the statute,”
we require “strict adherence to all statutory and regulatory
requirements.” Bond v. Commissioner, 100 T.C. 32, 41 (1993) (quoting
Taylor v. Commissioner, 67 T.C. 1071, 1077 (1977)). On the other hand,
if requirements are “procedural or directory in that they are not of the
essence of the thing to be done but are given with a view to the orderly
conduct of business, they may be fulfilled by substantial, if not strict
compliance.” Id. (quoting Taylor, 67 T.C. at 1077–78).
In this case statutory requirements must be met for there to be a
valid FASIT arrangement. We have held that if a taxpayer wished to
take advantage of subchapter S provisions, the taxpayer must comply
with all of the statutorily mandated requirements. Combs v.
Commissioner, T.C. Memo. 1989-206, 57 T.C.M. (CCH) 288, 290, aff’d,
907 F.2d 151 (6th Cir. 1990) (unpublished table decision); see also
Brutsche v. Commissioner, 585 F.2d 436, 439 (10th Cir. 1978), vacating
and remanding 65 T.C. 1034 (1976).
In Dirks v. Commissioner, T.C. Memo. 2004-138, 87 T.C.M. (CCH)
1403, 1405, aff’d, 154 F. App’x 614 (9th Cir. 2005), the Court declined to
apply the substantial compliance doctrine to the statutory 60-day
deadline applicable to individual retirement account rollovers under
section 408(d)(3)(A) because “the 60-day rule is not regulatory but is
found in the statute itself.” As in Dirks, the Court is asked whether the
substantial compliance doctrine applies to a Code section.
Respondent’s adjustments in the Notice of Deficiency are
primarily based on Code sections. The statute creating FASITs provided
five requirements for an entity to be treated as a FASIT, and these
requirements are in the conjunctive. See § 860L(a). Additionally,
Congress placed limits on the yields that regular interests in a FASIT
could provide to their holders and required unconditional and pre-
specified interest payments and return of principal. See § 860L(b)(1)(A).
The FASIT arrangement at issue was not a valid FASIT from its
inception because the Series A/E Stock did not meet the requirements of
regular interest as discussed supra Opinion Part II.A. The statute is
35
clear that all the requirements need to be met in order for an
arrangement to be treated as a FASIT. Accordingly, the substantial
compliance doctrine does not apply.
Petitioner has failed to show that the arrangement among it,
SAAN, Dynamo, and Chase was a valid FASIT from its inception, before
2003, and on October 22, 2004, when the FASIT repeal became effective.
Specifically, the Series A/E Stock was not a valid regular interest under
section 860L(a)(1)(B). Additionally, substantial compliance does not
apply to section 860L(b)(1).
IV. Beneficial Ownership
In the alternative, petitioner contends that it should not be
required to recognize or pay tax on the income from the FASIT assets
because it was not the beneficial owner of those assets. Petitioner
argues that the FASIT investors are the beneficial owners of those
assets.
The facts are inconsistent with petitioner’s argument. Petitioner
had legal title to the intercompany receivables set forth in the election.
Petitioner did not use the funds received from the issuance of the Class I
Note, the Class II Note, and the Series A/E Stock to acquire the
underlying intercompany receivables because it was already the legal
owner of the assets.
As asset manager, petitioner could replace the assets with
permitted assets without the consent of the investors. Only petitioner,
and not the investors, had legal recourse if debtors failed to make
payment on the intercompany receivables. The investors had only
contractual rights to amounts based on the proceeds from the
intercompany receivables.
Respondent contends that if the FASIT rules do not apply, the
assets held in the structure are corporate assets. Courts have applied
the following factors to determine the ownership of securities: (1) the
risk of investment loss, (2) the opportunity for investment gain, (3) the
ability to select and control the securities for investment, and (4) the
right to exercise other prerogatives of ownership. GWA, LLC v.
Commissioner, T.C. Memo. 2025-34, at *71. After application of the
factors we conclude that petitioner was the beneficial owner.
The risk of loss factor likely favors petitioner as beneficial owner
because Dynamo and Chase had no risks in relation to the underlying
36
assets and were limited to the recourse provided in the Class I Note and
the Class II Note. The opportunity for gain factor is neutral since both
petitioner and the investors had the opportunity for investment gain.
The third and fourth factors favor petitioner as the beneficial
owner. Petitioner, not the investors, was a party to the intercompany
receivables and had the right to sell or dispose of, change, or modify the
intercompany receivables consistent with the terms of the arrangement.
Additionally, petitioner relies upon Geftman v. Commissioner,
154 F.3d 61 (3d Cir. 1998), rev’g in part T.C. Memo. 1996-447. In
Geftman, the U.S. Court of Appeals for the Third Circuit, to which this
case is appealable absent a stipulation to the contrary, concluded that
corporations were the beneficial owners of certain mortgages by relying
upon two factors: (1) control over the property and (2) the right to
economic benefits. Id. The Third Circuit looked to who had actual
control over the mortgages and their benefits. In this case, petitioner
had control over the assets. Both petitioner and the investors had
economic benefits in the intercompany receivables, but only petitioner
held title, possession, and control over the intercompany receivables.
Petitioner also could sell or exchange the intercompany receivables.
Petitioner contends that the FASIT arrangement was designed as
a passthrough structure and that the yearly proceeds from the FASIT
assets went to pay returns to the Class I and Class II Noteholders and
any residual profits went to the Series A/E Stockholder. Petitioner has
not provided a legal or factual basis to support its argument that the
FASIT arrangement was a passthrough. From the record of this case,
petitioner has failed to show that it was not the beneficial owner of the
assets. 14
V. Whether the Series A/E Stock Was in Substance Debt or Equity
Upon cessation of a qualified FASIT, regular interest holders are
treated as exchanging their regular interests for interests in the
14 Petitioner did not raise the beneficial ownership argument until the filing of
its Pretrial Memoranda. Respondent contends that he would be prejudiced if we were
to consider petitioner’s beneficial ownership argument. We tend to agree; however, we
are able to decide this issue on the evidence before us. See Smalley v. Commissioner,
116 T.C. 450, 456 (2001); see also Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C.
1221, 1237 (1981) (stating that whether a taxpayer experiences the benefits and
burdens of ownership of an asset is a question of fact which must be ascertained from
the intent of the parties as evidenced by their written agreements).
37
underlying arrangement. Prop. Treas. Reg. § 1.860H-3(c)(2) and (3), 65
Fed. Reg. 5807, 5821–22 (Feb. 7, 2000). Interests in the underlying
arrangement are classified as debt or equity under general principles of
federal tax law. Id. If a valid FASIT never existed or ceased to exist,
the segregated pool of assets would be considered assets of the owner.
Id. para. (c)(1), 65 Fed. Reg. at 5821.
In this case petitioner would be the actual owner of the FASIT
assets. The underlying contracts would remain in effect. The interest
payments made to Dynamo would be deductible as interest expenses.
The payments made to the Series A/E Stockholders would be dividends
paid on equity and would not be deductible for U.S. tax purposes. As a
result of our conclusion that the FASIT was invalid, petitioner’s taxable
income should increase by an amount equal to the earnings on the
FASIT assets less the interest paid to Dynamo, petitioner’s asset
management fee, and any other expenses of the FASIT.
Petitioner contends, as an alternative argument, that the Series
A/E Stock is debt in substance and that the “dividend payments” on the
Series A/E Stock are in substance deductible interest. Respondent
contends that the Series A/E Stock should be treated as equity and not
debt. We agree with respondent.
In resolving questions of debt versus equity, courts have
identified and considered various factors. Calumet Indus., Inc. v.
Commissioner, 95 T.C. 257, 285 (1990); see also Dixie Dairies Corp. v.
Commissioner, 74 T.C. 476, 493 (1980). Petitioner has the burden of
showing that Series A/E Stock is debt. See Dixie Dairies Corp., 74 T.C.
at 493.
The Third Circuit, has identified sixteen factors to consider in this
analysis. Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir.
1968). The Fin Hay factors are:
(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
38
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.
Id.
In Scriptomatic, Inc. v. United States, 555 F.2d 364, 367–68 (3d
Cir. 1977), the Third Circuit identified the ultimate issue under Fin Hay
as whether the transaction, when measured by objective standards,
“would have taken the same form had it been between the corporation
and an outside lender.” “It is only within this framework that the many
factors listed in Fin Hay and in other court decisions in this area have
any meaning or function.” Id. at 368.
No single factor is determinative, and not all factors are
applicable in each case. Dixie Dairies Corp., 74 T.C. at 493. The “real
issue for tax purposes has long been held to be the extent to which the
transaction complies with arm’s length standards and normal business
practice.” Id. at 494 (quoting Estate of Mixon v. United States, 464 F.2d
394, 403 (5th Cir. 1972)). In our analysis we address the most relevant
factors.
A. Intent of the Parties
We analyze the objective facts to determine whether the parties
had a reasonable expectation of repayment, whether their intentions
comported with the economic reality of the debtor-creditor relationship,
and how they treated the relevant documents. See Lane v. United States
(In Re Lane), 742 F.2d 1311, 1316–17 (11th Cir 1984); see also Geftman
v. Commissioner, 154 F.3d at 68. Transactions between related parties
are “subject to particular scrutiny because the control element suggests
the opportunity to contrive a fictional debt.” Geftman v. Commissioner,
154 F.3d at 68 (quoting United States v. Uneco, Inc. (In re Uneco, Inc.),
532 F.2d 1204, 1207 (8th Cir. 1976)).
Petitioner contends that the parties intended the Series A/E Stock
to be debt because regular interests in a FASIT are statutorily treated
as debt. It further contends that the transaction was structured so that
the Series A/E Stockholder would receive yearly a predictable share of
39
income from the FASIT assets and a return of its invested capital at the
end of the transaction. Respondent’s position is that petitioner’s intent
to implement a FASIT is immaterial, and that the attributes of the
Series A/E Stock itself are those of equity and, accordingly, the
payments on the Series A/E Stock would not have been deductible as
interest payments.
Without the statutory exception, the parties to the FASIT
intended the Series A/E Stock to be equity. Petitioner labeled the Series
A/E Stock, and referred to it, as stock in employee emails, transaction
documents, and petitioner’s approval presentation. Even as far back as
Babcock & Brown’s promotional materials, SAAN’s interest was
characterized as stock.
The objective features of the Series A/E Stock further indicate
that, but for its being issued as part of the FASIT, the parties intended
the Series A/E Stock to represent equity. The Stock Certificate
pertaining to the Series A/E Stock relevantly provided its holder the
following rights and restrictions: (1) authorization of petitioner’s board
of directors to declare dividends on the Series A/E Stock, (2) provision of
corporate management rights, including the ability to vote for one of
petitioner’s directors, and (3) allocation of no rights typically afforded
corporate creditors.
Additionally, petitioner treated the Series A/E Stock as equity for
accounting purposes. The principal motivation to create a FASIT was
to allow dividend payments on the Series A/E Stock to be treated as
deductible interest payments. Petitioner intended that the French
taxing authority treat the Series A/E Stock as equity. Its own document
explaining the arrangement indicates that “so-called regular interests
are deductible regardless of the actual form of such interest.” Because
petitioner, aside from its intention to create a valid FASIT, treated the
Series A/E Stock as equity, this factor favors the conclusion that the
Series A/E Stock was equity.
B. SAAN’s Identity of Interests as Creditor and Stockholder
SAAN purchased the Series A/E Stock from an entity with which
it shared a common parent. The Series A/E Stock was part of a tax
arbitrage transaction, the benefits of which would accrue to the
multinational group as a whole. As a result, the interests of all parties
to the FASIT were not aligned with enforcing the rights afforded to them
by the instruments they held, but rather to keep the FASIT intact.
40
SAAN advanced approximately 98% of the funding of the FASIT
in exchange for the Series A/E Stock and expected, with minor
adjustments, pro rata returns. This indicates that SAAN’s advance was
made in exchange for an equity interest. Because of the allocation of
economic interests in the FASIT with respect to the Series A/E Stock
and the interrelatedness of the parties, this factor favors the conclusion
that the Series A/E Stock was equity.
C. Voting Rights and Participation in Management of
Petitioner
An increase of management rights resulting from an advance
generally indicates equity characterization. NA Gen. P’ship & Subs. v.
Commissioner, T.C. Memo. 2012-172, slip op. at 22. SAAN, as the Series
A/E Stockholder, was entitled to one vote per share on all corporate
matters and voted with the holders of petitioner’s common stock.
Further, SAAN was entitled to elect one member of petitioner’s board of
directors. This factor favors the conclusion that the Series A/E Stock
was equity.
D. Whether Petitioner Could Have Obtained Third-Party
Lending
“Under an objective test of economic reality it is useful to compare
the form which a similar transaction would have taken had it been
between the corporation and an outside lender, and if the shareholder’s
advance is far more speculative than what an outsider would make, it is
obviously a loan in name only.” Fin Hay, 398 F.2d at 697. A taxpayer’s
ability to secure financing under similar terms from a third party is
relevant in measuring the economic realities of a transaction.
Scriptomatic, 555 F.2d at 367; see also NA Gen. P’ship & Subs., T.C.
Memo. 2012-172, slip op. at 35. In other words, we inquire whether an
outside investor would have advanced funds on terms similar to those
agreed to by the shareholder. Scriptomatic, 555 F.2d at 368.
Petitioner argues that Chase’s minor investment in the
arrangement from 2001 to 2003 indicates that the FASIT was an
attractive investment to third parties. Respondent disputes this
argument.
Respondent’s expert Mr. Ahmad explained that the Series A/E
Stock would not have been marketable to an unrelated third party under
its terms for several reasons. Because of the additional risk posed by its
subordinated position in the FASIT’s capital structure, outside investors
41
would demand a higher return on the Series A/E Stock than the returns
on the Class I and II Notes and the underlying pool of assets.
According to Mr. Ahmad’s testimony, the Series A/E Stock
received the residual income from the FASIT assets, which was equal to
LIBOR plus 0.17% at the outset of the transaction. 15 This is a lower rate
of return than LIBOR plus 0.205%, which the initial pool of the
underlying FASIT assets offered. The Series A/E Stock’s return is also
lower than the expected return, LIBOR plus 1.75%, of the Class I Note
and the Class II Note. Mr. Ahmad concluded that as a result of its lower
rate of return, and because there were publicly available investment
grade debt securities that offered higher returns for similar risk at the
time the parties formed the arrangement, a third party investor would
not have invested in the Series A/E Stock. We find that this factor favors
the conclusion that the Series A/E Stock was equity.
E. The Risk Involved
An investor’s degree of risk and whether their advance to a
corporation is speculative are key factors in determining the economic
realities of a transaction. Scriptomatic, 555 F.2d at 367. Petitioner
argues that the lack of upside potential favors a conclusion that the
Series A/E Stock should be treated as debt.
Respondent’s experts Messrs. Ahmad and Cohen explained that
SAAN was exposed to numerous financial risks. These include the lack
of constraint on the credit worthiness of the FASIT assets, the illiquidity
of the investment, the lack of remedies or recourse if petitioner violated
terms of the Series A/E Stock, the lack of priority to or protection of the
FASIT assets against third-party creditors, the Series A/E Stock’s
position in the FASIT’s capital structure, and the uncertainty regarding
the amount of the liquidation preference the holder was entitled to at
redemption or liquidation. In conjunction these risks made investing in
the Series A/E Stock riskier than traditional debt instruments and favor
the conclusion that the payment for the stock was an equity advance.
15 At the outset the underlying pool of FASIT assets accrued interest at a rate
of LIBOR plus 0.205%, 0.005% of which funded the asset manager’s fee. Considering
the supplemental interest adjustment that equated to approximately 0.033% of the
principal amount of the Series A/E Stock, the rate of interest paid to the Series A/E
Stock was approximately LIBOR plus 0.17%.
42
F. Existence of and Labels Given to a Debt Instrument
The issuance of a debt instrument such as a promissory note,
bond, or debenture indicates debt, and the issuance of an equity
instrument such as a stock certificate supports equity characterization.
Anchor Nat’l Life Ins. Co. v. Commissioner, 93 T.C. 382, 404–05 (1989).
Regardless of form, a taxpayer is not relieved of its obligation to show
that it entered into a debt arrangement, and valid debt may exist
between parties even where no formal debt instrument exists. Litton
Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377–78 (1973).
Babcock & Brown’s promotional materials and petitioner’s
approval presentation characterized SAAN’s interest as stock or
preferred stock. Petitioner contends that even though the Series A/E
Stock was formally denominated stock of a corporation, it was created,
labeled, and treated like a regular interest in a FASIT, which by statute
is treated as debt. The Series A/E Stock would be treated as a regular
interest only if the statutory requirements of a FASIT were met.
Without the FASIT rules the Series A/E Stock would have been treated
as equity. This factor favors the conclusion that the Series A/E Stock
was equity.
G. The Relative Position of the Series A/E Stock in the FASIT’s
Capital Structure
Whether a purported creditor’s rights to receive interest and
principal payments are subordinated to other creditors’ is a factor in
whether the funds should be treated as equity. Estate of Mixon, 464
F.2d at 406. As discussed supra Opinion Part II.A.2, the Series A/E
Stock featured no guaranty that any specified amount would be repaid
as interest or principal. Petitioner structured the terms of the Series
A/E Stock such that it received the residual income and residual
principal upon liquidation from the FASIT assets. An interest entitled
to the residuary of a corporation’s earnings and assets is inherently
subordinated to the other creditors and/or shareholders of that
corporation.
The 2000 and 2003 AMAs provided that payments due on the
Class I Note, the Class II Note, and the Series A/E Stock were to be made
only from the revenue generated by the FASIT assets. Additionally, the
Class I Note and the Class II Note and the Series A/E Stock were to
remain outstanding if the arrangement was never, or ceased to be, a
43
FASIT. In such a case, the Series A/E Stock would have been in the
most subordinated position in petitioner’s capital structure.
Petitioner’s failure to show that the FASIT assets were protected
from its general creditors in the case of bankruptcy indicates that the
Series A/E Stock was subordinated to the general creditors and other
common shareholders of petitioner. Petitioner’s expert Dr. Cragg
testified that the Class I Note’s having priority over the Series A/E Stock
did not indicate that the instrument was equity because corporate
borrowers issue different tiers of debt.
Respondent’s expert Mr. Ahmad countered in his rebuttal report
that the Series A/E Stock was in the most subordinated position in the
transaction. He explained that the junior-most tranche in a
securitization is considered equity because it receives residual
cashflows. Its returns depend on the performance of the securitized
assets just as equity holders in a company rely on the performance of
the underlying business for their returns. We agree. This factor favors
the conclusion that the Series A/E Stock was equity.
H. Fixed Rate of Interest
Predictable and consistent interest payments, such as those
determined with reference to a fixed rate or variable rate with reference
to a benchmark rate, suggest a debtor-creditor relationship. Fin Hay,
398 F.2d at 696. Generally, periodic payments that vary in amount and
correlate with the undistributed profits of a business are considered
dividends on equity. See Himmel v. Commissioner, 338 F.2d 815, 817
(2d Cir. 1964), rev’g 41 T.C. 62 (1963).
The payments owed to SAAN as the Series A/E Stockholder were
subject to the discretion of petitioner’s board of directors and were
defined as the FASIT’s earnings less the payments owed on the Class I
Note, the Class II Note, and the FASIT’s expenses, effectively a residual
amount. Petitioner has not shown that the Series A/E Stock would
receive a fixed rate of interest. This factor favors the conclusion that the
Series A/E Stock was equity.
I. Contingency on the Obligation to Repay
Whether an advance of funds featured objective, economic factors
that suggest the lender took the customary steps, such as obtaining a
security interest in assets of the obligor, to ensure repayment helps
44
determine whether the advance gave rise to debt or equity. Geftman v.
Commissioner, 154 F.3d at 71–72.
With respect to both dividend payments and repayment of the
Series A/E Stock’s original issue price, SAAN was entitled to an amount
determined by the income, and FMV, of the FASIT assets. The timing
and amount of payment of such dividends were at the discretion of
petitioner’s board of directors. As discussed supra Findings of Fact Part
II.B, the residual interest in the cashflow of the FASIT and the
liquidation preference that the Series A/E Stockholder was entitled to
did not guarantee a return of the stock’s original issue price. SAAN had
no mechanism to enforce payment of dividends or to require repayment
of the full original issue price of the Series A/E Stock.
Further, SAAN’s right to a liquidation preference was not secured
by any assets of petitioner beyond the Series A/E Stock’s rights to the
residual cashflows of the FASIT assets and the liquidation preference.
The FASIT’s having a security interest in the receivables of API did not
serve as protection for SAAN’s interest specifically, which was limited
to the liquidation preference of the FASIT, but to the FASIT
arrangement as a whole. The security interest mitigated the credit risk
the FASIT was exposed to by holding the 2003 and 2005 Loans, but it
did not guarantee anything to SAAN as the Series A/E Stockholder.
These residual interests did not guarantee the Series A/E Stock
dividends at a predictable rate or unconditionally entitle SAAN to
return of the entire original issue price. This factor favors the conclusion
that the Series A/E Stock was equity.
J. Source of Interest Payments
If interest payments on an advance are funded by corporate
earnings, the advance looks like an equity contribution. Anchor Nat’l
Life Ins. Co., 93 T.C. at 406. When repayment is not dependent upon
earnings, the interest is more likely to be characterized as a loan. Id.
Under the 2000 and 2003 AMAs, dividends paid on the Series A/E
Stock were funded by the undistributed profits of the FASIT only, and
not from any of petitioner’s other assets. Further, petitioner failed to
follow the terms of the AMAs throughout the term of the arrangement
by paying to the Series A/E Stockholder additional profits earned as
interest from a money market account and after Chase’s withdrawal
from the arrangement. Since the source of the dividends was restricted
to the FASIT’s earnings, and the amounts of the dividends fluctuated
45
with the income the FASIT earned and the amount of FASIT assets it
held, this factor favors the conclusion that the Series A/E Stock was
equity.
K. Timing of Advance with Reference to the Organization of
the Corporation
If a corporation uses an advance of funds to acquire its initial
assets, or the advance represents a long-term commitment dependent
on the future value of the corporation’s assets, the advance looks more
like an equity advance. See S.P. Realty Co. v. Commissioner, T.C. Memo.
1968-156, 27 T.C.M. (CCH) 764 (citing Fin Hay, 398 F.2d 694); see also
Estate of Mixon, 464 F.2d at 410–11. Petitioner argues that because the
Series A/E Stock was issued long after petitioner’s formation, this factor
does not favor equity.
The Series A/E Stock had an interest in the FASIT arrangement
and not in all the assets of the corporation. The payments to the Series
A/E Stockholder depended on the success of the FASIT arrangement.
The Series A/E Stock represents an equity interest in the segregated
pool of assets. Accordingly, this factor weighs in favor of equity.
L. Debt Versus Equity Conclusion
Our review of the terms of the Series A/E Stock in the light of the
Fin Hay factors resulted in 11 factors favoring equity. Additionally, the
intent of the parties to the arrangement clearly favors the conclusion
that the Series A/E Stock was equity. Accordingly, the Series A/E Stock
should not be treated as a debt instrument.
VI. Conclusion
Petitioner has not established that the arrangement among itself,
SAAN, and Dynamo was a valid FASIT for the years in issue.
Additionally, the substantial compliance doctrine does not apply to
section 860L(b)(1), and petitioner did not show that it was not the
beneficial owner of the FASIT assets. Petitioner must recognize the
interest income generated by the FASIT assets. We further conclude
that the Series A/E Stock was in substance equity, and petitioner may
not deduct amounts paid as dividends to SAAN as deductible interest
payments.
46
We have considered the arguments made by the parties and, to
the extent they are not addressed herein, we find them to be moot,
irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered for respondent.