The timing of this court decision would make one nervous with the recent release of proposed Sec 385 regulations that dramatically increased loan documentation requirements. However, a closer reading of the facts of this case makes it clear that the Norse Group did not follow the small amount of documentation on the loans that they did have in place, changed interest rates on the loans at whim, and didn’t charge when it was convenient. A good call. — Rick Gimbert, CPA, Brady Ware International Tax Team Leader
The court found that the parties failed to consistently act with an arm’s-length creditor-debtor relationship, despite the obvious U.S. tax advantages of debt treatment to both sides — the portfolio interest exemption for the foreign seller and interest deductions for the U.S. buyer. But the court found that several of the formalities of debt weren’t undertaken and the U.S. entity put no money down. Moreover, the court held that the U.S. entity was liable for a substantial understatement penalty related to interest deductions it took on the putative debt.
The taxpayer, Norse Group, consisted of American Metallurgical Coal Co. and its subsidiaries, which included Heimdal Investment Co. The Norse corporations were domestic and the company had a significant amount of net operating loss (NOL) carry forward.
The court case involved a transaction between Lausanne and Heimdal that took place over the course of tax years 1995 through 2008.
Since 1984, Norse Services provided management services to Lausanne, a Liberian corporation. It also acted as that company’s agent in the United States and the two businesses had some directors in common.
In 1984, Lausanne purchased Heimdal from Norse. In 1986 Lausanne invested in Caithness Geothermal 1980 (CG) by contributing $1,080,000 in exchange for three limited partnership units (Units). CG was a domestic privately held partnership and independent power producer.
In 1991, distributions from CG caused Lausanne to turn a profit, which gave rise to a liability for U.S. branch profits tax. One of the common directors of Lausanne initiated discussions with Norse over how the partnership investment could be restructured to avoid “branch profits taxation problems.” The taxpayer sought advice from a U.S. accountant, who worked with the parties to come up with an agreement.
The eventual agreement dated December 1992 provided that:
The accountant advised in a memo that the transaction would be characterized as an installment sale for tax purposes, that Heimdal could use Norse’s NOL to offset the income it received from CG, and that Lausanne would defer recognition of gain on the sale of its CG partnership interest until Lausanne recovered the note’s principal.
The accountant also concluded that the interest paid to Lausanne would be considered “portfolio interest,” free from withholding taxes, provided Heimdal obtain a Form W-8, “Certificate of Foreign Status,” from Lausanne before making payment, and obtain an independent appraisal of the CG units to support the $5 million selling price. The parties never created Form W-8 or obtained the independent appraisal.
In 2002, the parties extended the term of the note. The buyer failed to pay interest in 2003 and 2004, and the seller subsequently allowed those years’ interest to accrue rather than finding the note in default. In 2006, the term of the note was extended again, and the parties agreed to reduced the fixed interest rate to 6% and prohibit prepayment of the principal. Despite the revised terms, the buyer continued to pay fixed interest at 12% rather than 6%.
The court concluded that the financing that Lausanne provided Heimdal was equity and not debt.
Citing factors from the controlling precedent, Estate of Mixon, (5th Cir. 1972), the court concluded that the parties lacked “a genuine intention to create a debt.” The factors in Mixon are used to answer the ultimate question: Was there a reasonable expectation of repayment and did that intention comport with the economic reality of creating a debtor-creditor relationship? A significant factor was the buyer’s lack, at the time of the transaction, of any assets to repay the putative debt (other than income from the purchased partnership interests).
According to the court, the fact that repayment was completely contingent on the success of the partnership investment favored equity classification. The court also noted that the contingent “excess cash flow” interest part of the agreement suggested that the seller’s position in the partnership investment hadn’t significantly changed.
The court further observed that there was no evidence that the agreement’s terms were even negotiated and that the contract’s conditions limiting the buyer’s activities gave the seller effective management of the buyer.
In the end, the court found that forgoing an appraisal, requiring no down payment, extending the note’s term repeatedly, failing to pay interest timely or, later, at the agreed-upon reduced rate highlighted the taxpayer’s “self-serving” claim of intent to create debt.
Note: Earlier this year, the IRS released controversial proposed regs addressing whether a direct or indirect interest in a related corporation is treated as stock, debt, or as in part stock and in part debt, for U.S. federal tax purposes. Much concern was expressed by the business community and others about the unintended consequences of these proposed rules.