United States

Ninth Circuit affirms debt classification in Hewlett-Packard case

Debt classification results in foreign tax credit denial

TAX ALERT  | 

In a recent case, Hewlett-Packard Co. v. Commissioner [1], the Ninth Circuit affirmed the Tax Court’s decision that Hewlett-Packard’s (HP’s) investment in a foreign corporation was appropriately characterized as debt, rather than equity as HP had claimed. As a result, HP was denied its claimed foreign tax credits stemming from the investment.

Foreign tax credit availability depended on equity treatment

In this case, the taxpayer, HP, purchased the preferred stock of Foppingadreef Investments (FOP), a Dutch corporation whose only activity was to invest in contingent interest notes. HP, as FOP’s preferred stockholder, received dividends from earnings based on FOP’s interest income. As a result of a variance in the taxation of accrued contingent interest between the U.S. and the Netherlands-the Netherlands taxed accrued contingent interest, while the U.S. did not-HP claimed “excess” foreign tax credits (FTCs) generated by FOP, which it intended to use to offset U.S. federal income tax on other foreign source income. 

To successfully claim these FTCs required characterizing HP's FOP preferred stock as equity for federal income tax purposes [2]. The IRS argued this preferred stock should be treated as debt. The Tax Court agreed, and now the Ninth Circuit has as well. 

Ninth Circuit focused on debt-like characteristics of preferred stock arrangement

In affirming the Tax Court’s decision [3], the Ninth Circuit concluded that the Tax Court made no error in finding that HP’s investment in FOP was most appropriately characterized as debt. When analyzing the Tax Court’s conclusion, the Ninth Circuit noted two specific facts of particular importance, that the investment had the a de facto maturity date, that HP had de facto creditor’s rights.

In regard to the presence of a de facto maturity date, the Ninth Circuit found no error in the Tax Court’s conclusion that the put option HP held with respect to the preferred stock, coupled with the fact that FOP would have negative earnings after 2003, represented a fixed maturity date. HP never intended to maintain the investment past that point. The Ninth Circuit found that it was appropriate for the Tax Court to consider the put as part of the overall transaction when analyzing the debt-equity issue.

Ninth Circuit also affirmed the Tax Court’s conclusion regarding de facto creditor’s rights. The Tax Court noted that HP’s income on the investment has highly predictable-calculated as 97 percent of FOP’s after-tax base interest on the notes it owned-and that HP had a contractual remedy against FOP and another party to the investment if the notes were not paid. Additionally, the Tax Court noted that, while the dividend payments to HP were based on the after-tax earnings of FOP, the transaction was structured in such a way as to assure that FOP’s earnings were largely predetermined. For example, FOP was subject to strict limitations on its business activities and investments, rendering its cash flows predictable.

Conclusion

Based on the de facto maturity date and creditor’s rights, together with other relevant factors, the Ninth Circuit agreed with the Tax Court that HP’s investment in FOP was most appropriately characterized as debt. Accordingly, the Ninth Circuit also agreed with the Tax Court’s disallowance of the FTCs claimed by HP related to its investment in FOP.

This case serves as a reminder to taxpayers of the importance of appropriately classifying investments as debt or equity. The debt-equity classification in this case affected the availability of FTCs. In other cases, the effect may relate to other tax issues, such as interest deductions or ownership determinations. Taxpayers should make sure to consult their tax advisors when considering an investment that may present elements of both debt and equity.

[1] No. 14-73047 (9th Cir 2017).
[2] A plan similar to HP’s would now likely run afoul of a regulation issued subsequent to HP’s FOP transaction, Reg. § 1.902-2(e)(5)(iv).
[3] T.C. Memo. 2012-135. 

 

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