INTERESTING CASE ON DEBT VS. EQUITY CHARACTERIZATION

An interesting case (Castle Harbour) came out earlier this year in regard to the age old dispute as to whether to characterize an investment in an entity as debt vs. equity. This case was discussed at length in the article Partner or Lender? Debt/Equity Issues Arise in Second Circuit's Reversal of Castle Harbour, By Richard M. Lipton and Jenny A. Austin in the October 2006 issues of the Journal of Taxation.

The characterization of debt vs. equity has significant income tax consequences. Usually, taxpayers desire the "debt" label since when the investment is paid back to the "lender," deductible interest may result to the entity. Further, such a payment will not be a taxable dividend if the entity is a Subchapter C corporation. The IRS usually finds itself on the other end of the dispute, arguing that the investment is equity, since this usually generates more overall income tax and is consistent with the maxim that the IRS will adopt the position in a matter that will generate the most tax.

What is interesting about the Castle Harbour case is that the usual roles were reversed - the IRS was arguing for "debt" treatment and the taxpayer was arguing for "equity." In making its argument for "debt" treatment, the IRS was making the arguments that taxpayers usually make. Since the IRS prevailed upon the appellate court to adopt its reasoning, the reasoning adopted by the appellate court can now be used AGAINST the IRS in future cases when the IRS is seeking its more usual "equity" characterization.

In determining whether an investment was debt or equity, the 2nd Circuit Court of Appeals indicated that the applicable test was whether the funds were advanced with reasonable expectations of repayment regardless of the success of the venture (indicative of debt) or were placed at the risk of the business (indicative of an equity investment). Here are some facts and arguments employed by the IRS and adopted by the Court that may be of use to future taxpayer litigants that are looking for "debt" treatment:

--The investor in the case would be allocated profits from the venture, albeit subject to a dollar cap. The Court noted that this could increase the investor's percentage return on its investment by almost up to 2.5%. Normally, the IRS would argue that such an equity kicker belies an equity investment. In the instant case, however, the court found that the additional 2.5% possibility of return was "a relatively insignificant incremental return" and nonetheless treated the investment as debt. Thus, the Court is leaving the door open to investors to allow for some equity upside (as long as it is not too substantial) and still obtain debt treatment.

--The Court concluded that an investment labeled as equity should be recharacterized as debt even when there was no fixed repayment date. This is another fact that will be of use to investors seeking debt treatment.

The article notes that in winning the case, the IRS gained extra tax revenue - but that the precedents established by the case may cost it many times that revenue in other cases.

TIFD III-E, Inc., 98 AFTR 2d 2006-5616 (CA-2, 2006), rev'g 342 FSupp 2d 94 (DC Conn, 2004).