Way back in 2001, I was an indentured servant aspiring manager at PwC when I was assigned to oversee the preparation of the tax returns of a large public utility by the name of PacifiCorp. For the next two years, I’d spend 1-2 weeks a month on location at PacifCorp’s main office in Portland, Oregon.
Looking back, I’ve got nothing but fond memories of my travels to PacifiCorp and the experiences garnered. Those trips earned me a friendship with the company’s tax director that remains to this day, introduced me to the beauty of the Pacific Northwest and the wonders of the Westin Heavenly Bed, and most importantly, it was from a PacifiCorp conference room that I first mustered the courage to call my future wife and tell her she was the most beautiful woman I’d ever seen.
My days on PacifiCorp also triggered a sea change in the focus of my career from compliance to consulting, because for the first time, I was being exposed to big, highly technical issues, and I dug it.
Foremost among the issues facing PacifiCorp was the deductibility of interest paid by PacifiCorp’s parent holding company to its foreign shareholder. The PacifiCorp stock had recently been acquired by this newly formed U.S. holding company, and the acquisition was financed in part through loans from the foreign shareholder. At issue was whether the sizable loans — totaling nearly $5 billion — would be respected as debt from a federal tax perspective, or whether they would be reclassified as equity, making the interest payments from the holding company to the foreign shareholder nondeductible dividend payments. Because the interest payments totaled nearly $1 billion over a three-year period, there was clearly a lot at stake.
By 2003, I would flame out of PwC in highly predictable fashion, putting an end to my trips to Portland before I’d had the opportunity to find out just what the firm’s tax geniuses had concluded: were the advances debt, or were they equity?
Today, my curiosity was finally answered, as much to my surprise, the PacifiCorp debt versus equity issue made it to the Tax Court, with the court deciding in PacifiCorp’s favor that the advances were in fact debt. Apparently, shortly after I left PwC, the IRS challenged the interest deductions, litigation ensued, and the issue was finally put to bed nine years later.
First, some background into the debt v. equity debate:
Whether an advance from a shareholder to a corporation is debt or equity is an important determination. If the advance is respected as debt, payments of interest back to the shareholder will be deductible to the corporation. To the contrary, if the advance is treated as equity under federal tax principles, payments of purported interest from the corporation to the shareholder will be reclassified as nondeductible dividends.
Any analysis of debt versus equity is highly fact specific; thus, to further an understanding of the court’s reasoning in respecting the advances in the immediate case as debt, the relevant facts are listed below:
- NAGP was a newly formed U.S. corporation established for the sole purpose of purchasing the PacifiCorp stock on behalf of a Scottish corporation, ScottishPower.
- As part of the acquisition, NAGP issued notes totaling $4.8 billion to ScottishPower.
- $4 billion of the notes had a fixed interest rate of 7.3% and matured in 2011.
- The remaining $800 million in notes had a floating interest rate and matured in 2014.
- Formal notes were issued, and both ScottishPower and NAGP treated the advances as debt on their financial statements.
- The notes ranked equally with other debt obligations of NAGP.
- All communication between the parties labeled the advances as debt, and the advances were treated as debt in SEC filings.
- While interest was not always timely paid, NAGP did eventually pay all interest owed on the notes, totaling nearly $1 billion over the three years.
- The interest was paid largely out of dividends made from PacifiCorp to NAGP.
- In 2002, PwC determined that the debt should be capitalized; thus, ScottishPower contributed enough cash to NAGP to allow them to repay the debt and remove it from their balance sheet. No future interest payments were necessary.
The IRS challenged the treatment of the advances, arguing that they represented an equity infusion and recharacterizing the interest payments as nondeductible dividends.
The Tax Court, however, sided with PacifiCorp. Because the court’s decision would be appealable to the Ninth Circuit, the Tax Court analyzed the advance according to the 11 factors previously utilized by the appeals court:
(1) the name given to the documents evidencing the indebtedness;
(2) the presence of a fixed maturity date;
(3) the source of the payments;
(4) the right to enforce payments of principal and interest;
(5) participation in management;
(6) a status equal to or inferior to that of regular corporate creditors;
(7) the intent of the parties;
(8) “thin” or adequate capitalization;
(9) identity of interest between creditor and stockholder;
(10) payment of interest only out of “dividend” money; and
(11) the corporation’s ability to obtain loans from outside lending institutions.
In its analysis, the Tax Court concluded that the advances were supported as debt by the following factors and for the following reasons:
(1) Because formal promissory notes were issued;
(2) Both advances had specified maturity dates;
(3) NAGP had sufficient funds, through PacifiCorp distributions, to repay the debt;
(4) If interest payments were late, ScottishPower had the right to call the notes, and NAGP pledged its PacifiCorp stock as security for the notes;
(6) The loan did not subordinate ScottishPower’s right to repayment to that of other creditors;
(7) The evidence indicates that the parties intended to create a debtor-creditor relationship; the choice of debt was not motivated by tax avoidance goals; the momentary delay in paying interest as it became due was not fatal; a subsequent short-term loan to NAGP to allow it to pay interest back to ScottishPower when PacifiCorp was temporarily barred from making dividend payments was not problematic;
(8) An 82% debt-to-equity ratio was acceptable given NAGP’s business risk; and
(10) NAGP had sufficient cash flow to pay the interest.
Based on the foregoing, the advances made from ScottishPower to NAGP were respected as debt, and the resulting interest deductions were permitted, thus concluding a once unresolved chapter in my life. So this is what it feels like, when doves cry.