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Promissory Notes Are Statements to Make Payments, Not Dividends

DEC. 9, 1999

FSA 200010032

DATED DEC. 9, 1999
DOCUMENT ATTRIBUTES
  • Institutional Authors
    Internal Revenue Service
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    corporate tax, stock vs. debt
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2000-7132 (10 original pages)
  • Tax Analysts Electronic Citation
    2000 TNT 49-68
Citations: FSA 200010032

UILC: 385.01-00

 

Release Date: 3/10/2000

 

                                             Date: December 9, 1999

 

 

                           CC:DOM:FS:CORP

 

                            TL-N-10306-94

 

    INTERNAL REVENUE SERVICE NATIONAL OFFICE FIELD SERVICE ADVICE

 

 

                           MEMORANDUM FOR

 

                     ASSOCIATE DISTRICT COUNSEL

 

                             ATTN: * * *

 

 

                                FROM:

 

                          DEBORAH A. BUTLER

 

               ASSISTANT CHIEF COUNSEL (FIELD SERVICE)

 

                              CC:DOM:FS

 

 

                              SUBJECT:

 

               Tax effect of a distribution of a note

 

 

[1] This Field Service Advice responds to your memorandum dated September 9, 1999. Field Service Advice is not binding on Examination or Appeals and is not a final case determination. This document is not to be cited as precedent.

LEGEND:

 

FP = * * *

 

FS = * * *

 

DP = * * *

 

Country X

 

Date 1 = * * *

 

Date 2 = * * *

 

Date 3 = * * *

 

Date 4 = * * *

 

Date 5 = * * *

 

Year 1 = * * *

 

Year 2 = * * *

 

Year 3 = * * *

 

Year 4 = * * *

 

$a = * * *

 

$b = * * *

 

$c = * * *

 

$d = * * *

 

$e = * * *

 

$f = * * *

 

 

ISSUE:

[2] Whether the rationale of Kraft Foods Company v. Commissioner, 232 F.2d 118 (2d Cir. 1956), applies to treat the distribution of notes from DP to its parent as a distribution with respect to stock (which would constitute a dividend to the extent of the earnings and profits of DP).

CONCLUSION:

[3] Because the rationale of Kraft Foods does not apply (for the reasons stated below), the distribution would not be given any tax effect. Instead, the note would be treated as a statement by DP to make payments in the future (according to the terms of the note).

FACTS:

[4] The taxpayer, DP, was the common parent of an affiliated group of corporations filing a consolidated Federal income tax return for Year 1, the tax year at issue. As of the date of the declaration of the promissory notes described below, DP owned all of the stock of several subsidiaries.

[5] All of the stock of DP is owned by FS, all of whose stock is owned by FP, a Country X corporation. FP also owns all of the stock of several subsidiaries, some of which (including FS) are Country X corporations and some of which are domestic. However, because these domestic subsidiaries are not direct affiliates of DP, they are not members of the DP consolidated group.

[6] On Date 1, subsidiaries of DP distributed interest- bearing, assignable, promissory notes, payable on Date 4, to DP in the aggregate amount of $b. DP in turn distributed these notes up the chain where they were assigned to various domestic subsidiaries of FP.

[7] On Date 2, DP submitted its five-year corporate plan. This plan stated that DP, on behalf of the issuers, did not intend to pay the notes during such five-year period, even though the scheduled payment date occurred within this period. Subsequent five-year plans, through the end of Year 3, also stated that DP did not intend to pay the nots during such periods.

[8] On Date 3, the issuer and holder of each note, both of which were affiliates of FP, each entered into an agreement postponing the payment of that note, which payment was due on Date 4.

[9] On Date 5, the parties restructured the payment schedule of the notes, with principal payments scheduled to begin in Year 2 and continuing through Year 4.

[10] The distribution of the notes by DP brought the total amount of its distributions during Year 1 to approximately $e, which was approximately $d in excess of the current and accumulated earnings and profits ("E&P") of DP. Thus, DP treated approximately $c of the distributions as dividends and approximately $d of the distributions as return of capital.

[11] As a result of the disposition of certain assets of the DP group to unrelated parties in Year 1 (with the proceeds distributed to FS, as well as the distribution of other assets of the DP group to FS in Year 1), the value of the DP group declined from approximately $f to approximately $a. In addition, the debts for which the DP group were liable as of the end of Year 1, including the notes, contributed to a decrease in the retained earnings of the DP group from approximately $d to ($d).

LAW AND ANALYSIS

Case law:

[12] DP argues that the distribution of the notes should be treated as a dividend. In support of its position, DP cites the case of Kraft Foods Company v. Commissioner, 232 F.2d 118 (2d Cir. 1956).

[13] In Kraft Foods, National Dairy ("ND") purchased all of the assets of Kraft-Phenix Cheese Corporation (the "taxpayer") and issued a note in partial payment therefor. ND then transferred most of these assets to the taxpayer in exchange for all of its outstanding stock.

[14] For several years, the taxpayer distributed most of its earnings to ND, which used such amounts to pay its debts, including its debt incurred to acquire the assets subsequently contributed to the taxpayer.

[15] For several years following the acquisition, ND filed a consolidated return which included the taxpayer. However, when Congress abolished the privilege of an affiliated group of corporations to file a consolidated return, the taxpayer's board of directors declared a dividend of $30 million. The form of the distribution was 30 notes, each for $1 million at 6% interest per annum, payable in approximately 14 years. Simultaneous with this declaration, the taxpayer revalued its assets. As revalued, the taxpayer had a value in excess of the amount of the distribution.

[16] However, it could not have distributed such amount in cash without liquidating a substantial portion of the business.

[17] For the first five years after the issuance of the notes (which were the years at issue), the taxpayer had sufficient earnings not only to pay ND the interest required by the notes, but also to distribute dividends to ND.

[18] In determining the tax consequences of the distribution of the notes, the Court applied certain debt/equity factors: (1) the parent-subsidiary relationship, (2) the fact that an initial equity interest was converted into a purported debt interest, (3) the alleged thin capitalization resulting from the transaction, and (4) the lack of a business purpose other than tax avoidance.

[19] After noting that transactions between a parent and its wholly owned subsidiary merit close scrutiny, the Court further noted that arm's-length transactions between a parent and a sub would nevertheless be respected. In this case, the Court concluded that, although the interest rate that ND charged the taxpayer was slightly higher than it had to pay for its own debt, such interest rate was neither unrepresentative nor uncompetitive. In addition, the Court concluded that, even though the debt was between a parent and a subsidiary, such debt would not necessarily be subordinated to debt owed by the taxpayer to outside parties. Thus, the Court refused to disregard the transaction at issue simply because it occurred between a parent and a subsidiary.

[20] The Service argued that the distribution represented originally invested equity since the notes were not issued in exchange for additional funds nor against accumulated equity. The court rejected this argument noting that the tax law allow earnings to be distributed as a dividend, see Treas. Reg. section 1.301- 1(d)(1)(ii), or in the form of a note (for example, following a recapitalization).

[21] The Service argued that the debt/equity ratio was disproportionate (although the opinion did not state such ratio). However, the Court calculated the ratio as 10:13, relying on market values to determine the value of the taxpayer's assets as opposed to relying on book values. The Court did not consider this ratio disproportionate.

[22] Finally, the Court refused to disregard the transaction simply because the taxpayer had no business purpose other than tax avoidance. The Court noted that the transaction was only entered into because of the change in the treatment of consolidated returns, that the parties were separate entities and the transaction affected the legal rights and obligations of each party.

Analysis:

[23] A transfer of funds from a corporation to a shareholder is considered debt, rather than equity, if at the time of the distribution the parties intended that it be repaid. Crowley v. Commissioner, 962 F.2d 1077, 1079 (1st Cir. 1992), citing Alterman Foods, Inc. v. United States, 611 F.2d 866, 869 (Ct. Cl. 1979), involving loans from a shareholder to a corporation. Courts typically determine whether the requisite intent to repay was present by examining available objective evidence of the parties' intentions, such as: the degree of corporate control enjoyed by the taxpayer; the corporate earnings and dividend history; the use of customary loan documentation, such as promissory notes, security agreements or mortgages; the creation of legal obligations attendant to customary lending transactions, such as payment of interest, repayment schedules and maturity dates; the manner of treatment accorded the distributions, as reflected in corporate records and financial statements; the existence of restrictions on the amount of the distribution; the magnitude of the distributions; the ability of the shareholders to repay; whether the corporation undertook to enforce repayment; the repayment history; and the taxpayer's disposition of the funds received from the corporation. Crowley v. Commissioner, supra. We discuss the relevant factors below.

Related Party Debt

[24] The advances in this case are subject to strict scrutiny because each purported creditor and purported debtor are related parties (i.e., all are affiliates of FP). See Matter of Uneco, Inc. v. United States, 532 F.2d 1204, 1207 (8th Cir. 1976) (quoting Cayuna Realty Co. v. United States, 382 F.2d 298 (Ct. Cl. 1967)) ("Advances between a parent corporation and a subsidiary or other affiliate are subject to particular scrutiny 'because the control element suggests the opportunity to contrive a fictional debt'"). See also P.M. Fin. Corp. v. Commissioner, 302 F.2d 786, 789 (3d Cir. 1962) (sole shareholder- creditor's control of corporation "will enable him to render nugatory the absolute language of any instrument of indebtedness") and Fin Hay Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968).

[25] However, there must be something more than this to support the inference that the parties did not intend to treat the advances as bona fide indebtedness. See Piedmont Corp. v. Commissioner, 388 F.2d 886 (4th Cir. 1968); Liflans Corp. v. United States, 390 F.2d 965 (Ct. C1. 1968).

Formal Indicia

[26] Each note has the formal indicia of indebtedness because it requires the payment of a sum certain (collectively $b) on a fixed maturity date (Date 3). See Commissioner v. O.P.P. Holding Co., 76 F.2d 11 (2d Cir. 1935) (provision for payment of a sum certain with fixed interest rate supports debt characterization). See also United States v. Title Guarantee & Trust Co., 133 F.2d 990 (6th Cir. 1943) (fixed maturity date one of most important factors in determining debt status).

[27] However, the parties twice postponed the payment date of each note, eventually establishing a payment schedule (as opposed to one maturity date). Therefore, this factor does not favor respecting the characterization of the notes as debt.

Treatment By the Parties

[28] Since "actions speak louder than words," the parties' treatment of the notes is crucial in determining whether its characterization as debt should be respected. See Yale Ave. Corp. v. Commissioner, 58 T.C. 1062 (1972). See also Waller v. United States, 78-1 USTC Paragraph 9394 (D. Neb. 1978) (failure to enforce outweighs formal indicia).

[29] As noted above, the parties twice postponed the payment date of the notes. In addition, the five-year plans of DP issued for the period that included the scheduled payment date (as well as subsequent periods) stated that DP did not intend to pay the notes during such periods. By these actions, the parties did not evidence a serious intent to pay the notes in a timely fashion. See Laidlaw Transportation Inc. v. Commissioner, T.C.M. 1998-232, 75 TCM 2598. Therefore, this factor does not favor respecting the characterization of the notes as debt.

Expectation of Repayment

[30] Not only must the purported creditor expect repayment, the expectation must be reasonable. Repayments dependent on the fortunes of the business indicate equity. Dixie Dairies Corp., supra; Estate of Mixon v. United States, supra. You have indicated that it was not reasonable for the holder of the notes to expect that the issuers had the means to repay the debt.

[31] First, the value of the DP group had been drastically reduced in size. This significantly reduced the amount of assets, and presumably as well the earnings, available to satisfy the debt. In other words, the ratio of the notes to the value of the assets increased substantially after these distributions.

[32] Second, the parties twice postponed payment of the notes. However, DP cannot argue that unforeseen factors caused these postponements. The five-year plans of DP stated that it did not intend to pay the notes during the period covered by such plans. Thus, it is clear that there was no serious expectation of payment of the note. See Laidlaw Transportation Inc., supra. Therefore, this factor does not favor respecting the characterization of the notes as debt.

Kraft Foods

[33] We agree that Kraft Foods is distinguishable. Based on the factors discussed above, the 30 $1 million note issued by the taxpayer to ND were clearly debt. First, the notes contained a formal indicia of debt. Second, the parties treated the notes as debt. The taxpayer made regular payments of interest (the principal was not due during the years at issue). In addition, the taxpayer made other distributions to ND. These payments and distributions were all out of the taxpayer's earnings. Third, the expectation of payment was reasonable considering the amount of earnings the taxpayer generated. Finally, the notes were issued only because Congress abolished the privilege of an affiliated group of corporations to file consolidated returns.

[34] By contrast, based on the factors discussed above, it is not clear that the notes are debt. In fact, the factors discussed above argue strongly that the notes should be disregarded and treated merely as a statement by DP to make payments in the future.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS:

[35] * * *

[36] Please call if you have any further questions.

                               By: ARTURO ESTRADA

 

                                   Acting Branch Chief

 

                                   Corporate Branch

 

 

cc:
DOCUMENT ATTRIBUTES
  • Institutional Authors
    Internal Revenue Service
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    corporate tax, stock vs. debt
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2000-7132 (10 original pages)
  • Tax Analysts Electronic Citation
    2000 TNT 49-68
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