The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 11, June 1999, Panel Publishers, New York, NY.

IRS EMBRACES "DEDUCTIBLE" PREFERRED

By Robert W. Wood, San Francisco

It may sound like an oxymoron, but tax deductible preferred stock may have come into its own. Tax deductible preferred stock is one of the most successful financial products of the decade. Despite its popularity, nagging doubts have lingered about its proper classification for tax purposes. Most advisors have felt it was properly treated as debt. However, in Notice 94-47, the IRS raised the possibility that this security might be regarded as equity.

This presents a curious conundrum. If preferred stock were treated as equity, then its utility would effectively terminate. After all, if it were equity, the periodic payments made to investors would not be treated as deductible interest expenses. For the past few years the administration's budget package has included provisions that would eliminate the possibility that such a security would attain debt status. Fortunately, despite the administration's persistence, those provisions were never enacted into law.

Key IRS Ruling

Fortunately, with the recent issuance of LTR 9910046, these doubts about the tax characterization of this security have largely been laid to rest. The IRS has told us unequivocally that in its judgment, this security will be viewed as debt.

In most cases, tax deductible preferred stock is created when a corporation establishes an entity (most traditionally a partnership but, more recently, a trust) in which the corporation owns all the common equity interests. At the same time, the entity sells preferred equity interests to investors and the funds so raised are then loaned to the corporation. The interest payments on the loan fund the "dividend" payments to the preferred equity holders.

Structure of Deductible Preferred

One critical element to this kind of arrangement is that the corporation obtains the right to extend the interest payment period, normally for as long as 60 months. However, if this extension option is exercised, the corporation is precluded from paying dividends with respect to its stock. Moreover, the loan is subordinated to senior indebtedness. The loan will have a relatively long term. When these securities were first created the term was typically 50 years, although more recently a more common duration seems to be 30 years. The loan also normally features an opportunity to extend the debt's duration if certain conditions are met.

In analyzing the character of this instrument, the IRS turned to Notice 94-47. That pronouncement was issued in response to transactions, most prominently tax deductible preferred stock, in which instruments were designed to be debt for tax purposes but, at the same time qualify as equity for regulatory, rating agency and financial accounting purposes. If the instrument exhibited a preponderance of debt characteristics it could attain debt status for tax purposes, notwithstanding its contrary treatment for nontax purposes.

This may be one of the few areas where the form of a transaction does not control (or seem even to have a significant bearing) on its tax treatment. Tax deductible preferred exhibits the requisite surfeit of debt characteristics. The factors the IRS analyzed included a smattering of items.

1. Fixed Maturity. It is relevant whether the instrument features an unconditional promise to pay a sum certain, at a fixed maturity date, in the reasonably foreseeable future. In the case of tax deductible preferred stock, the debtor has an unconditional obligation to repay by a certain date. Renewal may be OK, as long as renewal of the loan was not automatic and was subject to the satisfaction of certain conditions. Typical conditions would include the preservation or improvement of the debtor's credit rating. Accordingly, this right to "postpone" payment was not taken into account.

Moreover, the stated maturity date was, in the case under scrutiny, found to be reasonable. After all, the debtor had been in existence for a significant number of years, conducted a substantial operating business and had an unblemished history of repaying its debts. Accordingly, despite the extended maturity date, it was reasonable to conclude that the debtor would be in existence at the maturity date and would be, at that time, in a position to defray its obligation.

This type of analysis, which focuses on business prospects and the venerability of the issuer, strongly suggests that issuers of even 100 year bonds will be vindicated (because these instruments, too, will constitute debt) in cases where the issuer possesses a business history that would enable one to predict that it will be functioning successfully when those instruments mature.

2. Enforcement. Another relevant inquiry is whether the holders possess the right to enforce payment. If an event of default occurs, the holders of the instrument (the partnership or the trust) have certain rights as creditors. However, because the entity is controlled by the debtor, those rights could be dismissed as meaningless. Nevertheless, here they were not so dismissed because the debtor's obligations were also for the benefit of the holders of the preferred securities. Those holders are entitled to enforce the loan agreements directly against the debtor.

3. Subordination. Another issue is whether the rights of holders are subordinated to the rights of general creditors. Here, the instrument was not subordinated to unsecured debt of general creditors.

4. Management Participation. The holders of securities had very limited rights to participate in management. Further, the debtor was not "thinly capitalized." The creditor (the partnership or trust), moreover, did not own stock in the debtor, so the negative implications associated with "proportionate ownership" of stock and the instrument being evaluated were not present. Finally, the instruments were labeled debt.

5. Nontax Characterization. It is still relevant whether the instruments are intended to be debt or equity for nontax purposes. This factor, thought to be the one that might tip the scales in favor of a finding that the instrument was disguised equity, has proven to be not nearly as forbidding as was originally feared. The IRS observed that these securities, due to their long maturity, subordination and the issuer's ability to defer the payment of interest, attain a degree of equity credit from the various rating agencies. Nevertheless, the ruling concludes that this is not inconsistent with the treatment of the preferred securities as participations in the loan (from the partnership or trust to the corporation) or with the treatment of the loan as debt.

For financial accounting purposes, the loan is eliminated in the group's consolidated financial statements. On the other hand, if stand alone financial statements were prepared the loan would surely be recorded as debt. Accordingly, despite the contrary implications one may legitimately derive from Notice 94-47, it seems reasonably clear that the nontax treatment of an instrument—normally as some species of equity—will not be a decisive (or arguably even a particularly important) factor.

Last Hurdle

As if the foregoing conditions were not severe enough, there are a few additional requirements that need to be observed. To secure its interest deduction, the debtor also must demonstrate that the transactions that compose the typical issuance of tax deductible preferred possessed economic substance. (This almost sounds like the near-mystical partnership rule of "substantial economic effect"!) Fortunately, this factor is generally easy to demonstrate. The debtor, after all, generally entered into the transactions to obtain funds at lower costs and, in general, to reduce its cost of capital.

Moreover, the fact that the partnership or trust is something of a conduit, which earns no economic profit, does not imply that the series of transactions lacks the requisite substance. What it receives from the debtor it promptly passes on to the holders of the preferred. Although the partnership or trust is admittedly a somewhat transparent vehicle, the underlying transactions (aimed at reducing capital costs for the debtor), clearly have economic substance. With the issuance of Letter Ruling 9910046, any residual doubt about the efficacy of this product should be dispelled.

IRS Embraces 'Deductible' Preferred, Vol. 7, No. 11, M&A Tax Report (June 1999), p. 1.