Office of Chief Counsel

..

Office of Chief Counsel

Internal Revenue Service

memorandum

CC:WR:LA:TL-N-2824-99

date:

to:

from:

subject:

February

3, 2000

Tere Itokazu

Financial

Products

IRS, Los Angeles

Marilyn

District

--------

Specialist,

FP1227

Devin, Attorney

Counsel,

Los Angeles

----------------

----- -- -------

- Debt-Eouitv

You have requested

an informal

opinion

as to a potential

debt-equity

issue arising from

Senior Debentures,

For the reasons discussed

adjustment

should be pursued.

Issue

from District

Counsel in this case

the Taxpayer’s

issuance

of certain

herein, we do not believe this

-------- --------------------- formerly

known as ---- ------ ---------- -------------was fm--- ---------------- ------- --- -- California

corporation------ ---------- -------- --- -successor

formed

in ----- under the laws of --------------- --- -- -------------international

----------------company,

with --------- -------- ----- ---------accounting

for somewhat

less than half its revenues,

------- --------------------------------activities

accounting

for an equal amount,

and -----------products

--------------the remaining

-- percent

of annual revenues.

The early

------- were a period of ------ ---------------- ---------- ----- ------ for

the Taxpayer,

which consequently

sought an infusion

of new funds. Following

the creation

of an Indenture

with

---------- ------- in ------- the Taxpayer

issued

a substantial

series of debt securities,

the proceeds

of which were to be used

The offerings

consisted

of up to ---- -- -------“for general corporate

purposes.”

dollars of “Medium-Term

Notes” in --------------- including

$ ---------------in

“Senior Debentures”

in ---- -------- Your question

deals with these Senior

.

Debentures.

According

to the “Pricing Supplement”

to the --------------- Prospectus

and Supplement,

these

---- percent debentures

were- --- ---- ---- -ear notes,

with a maturity

date of ---- ----- -------- You see these debt instruments

as the

source of a possible

tax ------- --- ------- of their unusually

long term.

In your

view, the remoteness

of the maturity

date diminishes

the investors’

right to be

10650

repaid

equity

to such an extent

than with debt.

that

the instruments

may have more

in common

with

Should these “ --------Bonds” be recharacterized

as equity, of course,

the Taxpayer

would not be entitled to deduct the amounts

it has paid (and will

pay) as interest

thereon.

Discussion

Periodic payments

made with respect to a debt obligation

are deductible

as interest

under Internal

Revenue Code Section 163, but only if the obligation

is a valid indebtedness

of the payor.

“The classic debt is an unqualified

obligation

to pay a sum certain at a reasonably

close maturity

date along with

a futed percentage

in interest

payable regardless

of the debtor’s income or the

lack thereof.

While some variation

in this formula

is not fatal to the taxpayer’s

effort to have the advance treated as a debt for tax purposes,

. . too great a

variation

will _.. preclude

such treatment.”

Gilbert v. Commissioner,

248 F.2d

399, 402-03

(2d Cir. 1957).

Whether

an instrument

represents

indebtedness

or an equity investment

for federal income tax purposes

depends on the facts and circumstances

of

each case. No particular

fact, standing

alone, is conclusive.

John Kellev Co. v.

Commissioner,

362 U.S. 521 (1946).

As outlined

in your request

to our office,

there is an array of factors to consider

in any debt vs. equity analysis.

The

ones you delineate

are:

.

.

.

g

.

.

n

.

whether

there is an unconditional

promise to pay a sum certain on demand

or at a fixed maturity

date that is in the reasonably

foreseeable

future;

whether

holders of the instrument

have the right to enforce payment

of

principal

and interest;

whether

the holder’s

rights are subordinate

to those of general creditors;

whether

holders have the right to participate

in the management

of the

issuer;

whether

the issuer is thinly capitalized;

whether

the holders of the instrument

are, in fact, the shareholders

of the

issuer;

how the instrument

is labeled by the parties; and

whether

the instrument

is consistently

treated as debt for other, non-tax

purposes

purposes.

Your

maturity

primary

concern is the first

date

---- years in the future

of the above factors.1

is hardly “foreseeable.”

You logically

note that a

But the operative

test

r Your request does also point out two other features of the bonds: (1) there are limits on

the debenture

holders’ rights to enforce payment, in that not less than -- percent of them

~-’ would have to act in concert in the event of default; and (2) the debentures,

being unsecured,

rank equally with all other senior unsecured indebtedness

of the Taxpayer; you refer to their .

subordination

to the rights of other creditors with respect to assets of the Taxpayer’s subsidi-

.

is reasonableness,

rather than foreseeability,

and reasonableness

can only be

addressed

in context. You have not given any facts about the Taxpayer’s

capital

structure

or credit rating, but it is in general known as a healthy,

stable, global

corporation,

and we are probably

safe in assuming

and ,eat there was no question

of

excessive

debt or “thin capitalization,”

or of an unsatisfactory

credit rating when

these debentures

were issued. proceeding

on these assumptions,

was there anything

unreasonable

about the debentures’

----ear term?

In Ruspvn COIV., 18 T.C. 769 (1952), an 89.year term was found to be

acceptable

where the period was substantially

coextensive

with the term of a ground

lease on the corporation’s

real property.

In Monon Railroad v. Commissioner,

55

T.C. 345 (1970), acq., 1973-2 C.B. 3, the Court found a debt with a term of 50 years

to be reasonable,

since “the substantial

nature of the [taxpayer’s]

business,

and the

fact that it had been in corporate

existence

since 1897, or 61 years prior to the

issuance

of the debentures”

were all taken into consideration

by the Court.

In Swobv Corporation,

9 T. C. 887 (1947), on the other hand, the Court found a

purported

debt obligation

of 99 years to be more akin to equity. But that was

because the context did make 99 years unreasonable:

the 99-year obligation

had

been issued by a corporation

whose principal

asset had an anticipated

life at the

time of acquisition

of less than a third of that span.

How could the “lenders”

anticipate

being repaid?

Even 15. and 20-year terms have been held excessive,

where circumstances

so dictated.

See, e.g., United States v. Snyder Bros. Co., 367

arks

in the event of the subsidiaries’

liquidation

or reorganization.

Regarding the enforcement

rights, you are correct that the “right to force payment of the

sum as a debt in the event of default’ is a very significant

factor in a debt vs. equity analysis.

United States v. South Georvia Rv., 107 F.2d 3, 5 b Cir. 1939). However, there is considerable

authority

that requiring the concurrence of a certain percentage of creditors in order to

accelerate maturity upon default is not inconsistent

with indebtedness,

since even creditors

have an interest in preventing a minority from “upsetting

the financial applecart if there should

be a default of no genuine economic consequence.”

Luden’s, Inc. v. United States, 196 F. Supp.

526, 533 (E. D. Pa. 1961); Cum, v. Commissioner,

43 T.C. 667, 686 (1965).

Regarding the subordination

question, you may be placing too much weight on the

provision you have quoted from the Prospectus.

True, “subordination

necessarily destroys one

of the essential rights of the creditor, and the willingness

to subordinate

is indicative

of equity

investment.”

Sarkes Tar&n.

Inc. v. United States, 240 F. 2d 467, 470-71 (7* Cir. 1957).

However, the Prospectus merely states that these debenture

holders’ rights to the assets of the

Taxpayer’s

subsidiaries

in the event of the subsidiaries’

liquidation

will be no greater than the

Taxpayer’s rights (except as a creditor) in that situation.

This provision does not subordinate

the rights of the debenture

holders to any of the Taxpayer’s general creditors’ rights.

Neither of these provisions is atypical ins comparable

public debt offerings, and we do

not think that in this case they can be said to militate more than a negligible amount

in favor

of a finding of equity.

3

F.2d

379,

980, 984 (5th Cir. 1966), cert. denied, 368 U.S. 956 (1967);

397 (1965), affd. 368 F.2d 125 (5th Cir. 1966).

Reef Corp.

24 T.C.M.

Obviously,

even multi-national

companies

split up, merge, disappear,

or change

their shape and name, and it is unlikely

that any given corporation

will be around

for

---- years in its present form. But that is different

from saying that something

exists

now which wiIl prevent the Taxpayer

from fulfilling

its obligations

to these investors,

or

that something

exists now that should warn these investors

that the debt wiII not be

repaid.

In short, we would have to point to something

about the long term of these

debentures

that makes it more likely that those who purchased

them did so with the

intent of putting

their money at the risk of the Taxpayer’s

business,

rather than simply.

lending it with the expectation

of repayment.

Paradoxically,

although

this question

is the crux of the issue, it is disingenuous

to insist that purchasers

of these debentures

were thinking

about repayment.

As noted

by many of today’s financial

market

observers,

“in the case of even conventional

longterm debt with a term of 30 years, the bulk of the present value of the security

is not in

the right to receive principal

back at maturity

but in the right to receive periodic

When viewed from this perspective,

the length of the term of an

interest

payments.“z

instrument

is only a minor factor in the debt equity analysis.3

Thus, whether

we seriously

address the question

of the investors’

expectation

of

repayment,

or whether

we recognize

the reality that the debentures

probably

represented no more than a secure income stream to them, the answer to the debt-equity

query is the same: the purchasers

did notbelieve

they were putting

their funds at the

risk of the Taxpayer’s

business.

The analysis

in your inquiry

relied heavily on Notice 94-47, 1994-1 C.B. 357,

which was published

when the Service became aware of a growing number

of corporate

taxpayers’

increasingly

aggressive

financing

schemes. The Notice announced

that such

schemes would henceforth

be more carefully

scrutinized,

and laid out several factors

that would receive close attention.

One of the Service’s articulated

concerns

was the

trend toward issuing purported

debt that had a variety of equity features,

including

those issues with exceptionally

long maturity

periods.4

2 HARITON 86 GARLOCK, “Federal Income Taxation of Debt Instruments”

(3d ed.), cited in

Sheppard, ‘News Analysis: Toward Straightforward

Section 385 Guidance,” 94 TNT 218-4, Nov.

7, 1994.

3 “[Alny security is really just a stream of payments.”

Sheppard, supra. “Extending

the

maturity of a conventional

debt instrument

(even to infinity) does not give it any fundamental

attribute

of equity.”

Myers, Treasury Tax Correspondence,

97 TNT 74-27, April 2, 1997.

4 From 1995 through 1997, dollar-denominated

century bonds were issued by no fewer than

53 corporations,

for a principal amount of $12.5 billion. The Financier, Vol. 4, Issue 4,

November 1997.

4

The Notice’s discussion of long-term debt, however, contained nothing new or

different. The Service merely cautioned taxpayers that they should be wary of relying

on cases such as Monon Railroad, supra, for purposes of treating otherwise doubtful

instruments as debt, rather than equity. It never came close to saying that a long term,

even an exceptionally long term, would alone tip the balance in favor of equity treatment, nor would that factor weigh any more heavily than it had in the past. Basically,

the Notice merely reiterated that “[t]he reasonableness of an instrument’s term ._. is

determined based on all the facts and circumstances, including the issuer’s ability to

satisfy the instrument. A maturity that is reasonable in one set of circumstances may

be unreasonable in another if sufficient equity characteristics are present.”

Thus the traditional debt-equity analysis is still controlling, and in the absence

of any significant facts weighing against debt and in favor of equity, we do not see how

we could support your proposed disallowance of interest with respect to these

debentures.5

Conclusion

If counsel can be of further assistance, please feel free to call. My number is

213/894-7101.

5 (b)(2)High

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