Corporate Taxation Chapter Three: Capital Structure

Transcription

1 Presentation: Corporate Taxation Chapter Three: Capital Structure Professors Wells January 31, 2018

2 Chapter 3 Capital Structure of the Corporation Options Structuring Corporation s Capital: 1) Common stock (voting, non-voting, and stock rights & warrants) 2) Preferred Stock (qualified preferred stock, nonqualified preferred stock, and convertible preferred stock) 3) Debt (convertible or nonconvertible). Debt can take many forms including bonds, debentures, notes, and trade payables. 2

3 Reasons for Corporation to Use Debt (Rather than Equity) 1) Interest on debt is deductible; dividends paid are not deductible to the corporation. 2) Repayment of the debt constitutes tax basis recovery to the lender and not a dividend distribution; redemption of the stock may be an ordinary dividend event, not a capital gains event (but both 20% tax). 3) Bad debt deduction may not be a capital loss. 3

4 Beneficial Effects of Corporate Debt Leveraging Enhance the corporation s return on equity (ROE) component and, thereby, increase the corporation s earnings per share (EPS). Capital Debt (10%) Equity Profits Return on Equity Example 1: 100% Equity Financing % Example 2: 50:50 Debt/Equity % If shares are normally selling at some multiple of earnings per share, what would happen when the earnings per share are increased by significant debt leveraging? What is permissible debt to equity ratio? Caution: Leverage is a two edged sword. 4

5 Impact of the ATRA 2013 Legislation Re Dividends Tax Rate 1) Dividends (and capital gains) are taxed at a maximum 20% to individuals. 2) Cf., interest income (to the lender) taxed at up to 39.6 percent (i.e., a 19.6 percent tax rate differential from the 20% rate for individuals). 3) But, interest expense is deductible at the corporation level; dividend distributions are not deductible to the corporation. 5

6 Alternative Shareholder Beneficial Tax Planning Hold the shares for capital appreciation and eventual recognition of deferred capital gains (or 1014 tax basis step-up at death for shares held). Corporation can use stock buy-backs (market repurchase programs) to compress the shareholder equity base and increase the per share earnings (and, thereby-hopefully- contribute to increased stock appreciation). 6

7 Debt vs. Equity Characterization p.122 Significant factors in differentiating between debt and equity (a fact question) include: 1) The form of the obligation what existence of the indicia of a debt, e.g., promissory note? 2) Debt/equity ratio thin capitalization? And what is debt for determining this ratio? 3) Intent to create a debt (is interest actually paid?). 4) Proportionality really a super factor? 5) Subordination inside debt/hard to avoid? See articles cited in Note 18 on p.123 7

8 Certain Debt vs. Equity Issues p.124 Is an IRS private letter ruling available to assure the classification of debt as such for federal income tax purpose? No. Rev. Proc , 4.02(1) this is a fact issue. What treatment of shareholder guaranteed debt: recharacterized as an equity contribution? Plantation Patterns case (p.124 n.27) says yes if the company is inadequately capitalized and the shareholder guarantor is in substance the primary borrower. 8

9 Indmar Products Co., Inc. v. Commissioner p.126 FACTS: Advances outstanding for long time. Advances were undocumented (no notes) initially. No maturity date. 10% interest rate. Indmar classified the advances as debt on its books and deducted interest. Hoffman Advances (10% i-rate) Tax Court: Held that the advances were equity. Indmar Advances (10% i-rate) Rowe 6 th Circuit: Held that the advances were debt for tax purposes. Debt is an unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in interest payable regardless of the debtor s income or lack thereof. Some variation from this formula is not fatal Note the factor analysis in the court s opinion. 9

10 What Varieties of Debt p.138 Notice 94-47: If holder must receive stock and cannot elect otherwise, then the instrument is equity Contingent convertible debt securities can be debt. See Rev. Rul contingent convertible debt. 10

11 Code 163(I) Interest Expense Deduction p.139 General Rule: The debt is payable in the equity of the issuer (or a related party). No deduction is allowed for interest paid or accrued on this disqualified debt instrument. Exception: Rev. Rul , Merrill Lynch s feline prides 5 year note and 3 year forward contract to purchase issuer s stock; the interest expense is deductible. Similar ACES Units, PEPS Units, and Upper DECS. Although the economic return is linked to the equity return, the issuing corporation does not have the option to redeem with company stock. Corporate planning objective: debt for tax and equity for financial reporting why? 11

12 Code 385 p.141 Section 385(a): The Secretary is authorized to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness (or as in part stock and in part indebtedness). Section 385(b): includes a list of non-exhaustive factors that may be taken into account. Section 385(c): issuer s characterization of an instrument is binding on the holder. 1. Enacted. See Tax Reform Act of 1969, PL , 83 Stat. 487 a. Amended by Omnibus Budget Reconciliation Act of 1989, P.L , 103 Stat to expressly authorize Secretary to treat an instrument as part stock / part debt. b. Amended by Energy Policy Act of 1992, Pub. L , 1936(a), 106 Stat. 3032, which added Section 385(c) to provide that the issuer s characterization of an interest is binding on the issuer and all holders (but not the Secretary). 2. Prior Effort: a. Proposed: Notice of Proposed Rulemaking, 45 Fed. Reg. 18,959 (May 24, 1980) b. Finalized: TD 7747, 45 Fed. Reg. 86,438 (Dec. 31, 1980); amended by TD 7774, 46 Fed. Reg. 24,945 (May 4, 1981); amended by TD 7801, 47 Fed. Reg. 147 (Jan. 5, 1982); amended by TD 7822, 47 Fed. Reg. 28,915 (July 2, 1982) c. Withdrawn: TD 7920, 48 Fed. Reg. 50,711 (Nov. 3, 1983) 3. New Effort: a. Notice of Proposed Rulemaking, 81 Fed. Reg. 20,912 (April 4, 2016). b. Finalized T.D. 9790, 81 Fed. Reg (Oct. 21, 2016) 12

13 Final 385(b) Regulations p.140 Common Law Applies First. If an instrument is otherwise considered a debt instrument under the common law, then the section 385 regulations may still recast it as equity if those regulations apply. The controversial final regulations under section 385 have the following main parts: I. Operating rules (Reg and -2(d) and -3(g)(3)): the final regulations apply a recast rule for related party debt to equity for instruments issued by a covered member (a domestic issuer - so foreign issuer debt instruments are not addressed) to an expanded group member (a new affiliated group definition). II. Documentation and Maintenance Requirements (Reg ): Formal documentation and creditor oversight is required as a prerequisite to debt characterization. III. Per se and Funding rules (Reg ): Even if an instrument meets the formal documentation and maintenance requirements, it can still be recharacterized as stock if the debt instrument is issued in specified transactions or within 3 years of a specified transaction. IV. Consolidated group rule (Reg ) exception to these rules remains unchanged. V. General Anti-Abuse Rule (Reg (b)(4)): Debt issued with a principal purpose of avoiding the application of -2 or -3 are subject to being treated as stock. 13

14 Base Erosion and Profit Shifting: First Responder: Old Section 163(j) Disallowed interest deduction for disqualified interest if two threshold tests were met: 1) Debt-to-equity ratio exceed 1.5:1 2) Net interest expense > 50% of ATI Base Erosion Defense: 163(j) Earnings Stripping Rules Foreign Parent Interest Income is Low- Taxed in foreign Country Disqualified Interest was interest paid 1) Related parties US Subsidiary 2) Unrelated parties with RP guarantee 3) To a REIT by a taxable REIT subsidiary Any disallowed interest could be carried forward indefinitely. Interest Deduction Reduces US Tax Base Open Issue: What happens to theinterest expense carryforward from the old section 163(j)? Old 163(j)(1)(B) would treat c/f as part of interest in the carryforward year. Does it carryover and used under new 163(j)? 14

15 Base Erosion and Profit Shifting: New Section 163(j) Limits deduction for all business interest to the sum of 1) Business interest income 2) 30% of ATI 3) Floor plan financing interest 163(j) limit: business interest + 30% ATI + floor plan financing interest What is business interest? Base Erosion Defense: 163(j) Earnings Stripping Rules Foreign Parent US Subsidiary Interest Income is Low- Taxed in foreign Country Interest Deduction Reduces US Tax Base Answer: Business interest does not include interest from trade or business as employee, interest related to electing real property business, electing farm business interest, interest related to furnishing electrical energy, water, or sewage or gas or steam or transportation of gas or steam by pipeline. Small Business Exception: 3-year average gross receipts < $25 million. 15

16 Base Erosion and Profit Shifting: New Section 163(j) (cont.) Adjusted Taxable Income excludes the following 1) Any item of income, deduction or loss not allocable to a business 2) Any business interest or interest income 3) Any NOL deduction under 172 4) Section 199A deduction 5) Before 2022, any depreciation, depletion or amortization ( 163(j)(8)). Base Erosion Defense: 163(j) Earnings Stripping Rules Foreign Parent US Subsidiary Business interest that is disallowed is carried forward indefinitely. Interest Income is Low- Taxed in foreign Country Interest Deduction Reduces US Tax Base As to partnerships, Section 163(j) applies the ATI limit at the partnership level but if there is a limit or excess limitation that attribute is carried forward at the partner level. No netting across partnerships. This is a partnership by partnership test. 16

17 Problem Facts & Balance Sheet FACTS: Total equity Aristocrat contributions of $240,000. Debt of $900,000 from Friendly. Additional debt from shareholders of $900,000. Bank Cash ($80) $900 Debt Bldg (B=20 FMV=80) Baker Newco p.145 Chef Assets Adj. Basis F.M.V. Liabilities and Capital Cash $1,920,000 $1,920,000 Liabilities: Building 20,000 80,000 Friendly Goodwill 0 40,000 Bank $900,000 Shareholder Loans 900,000 Capital: Common Stock 240,000 $1,940,000 $2,040,000 $2,040,000 17

18 Problem 1(a) Debt-Equity Ratios p.145 Three shareholder loans for $300,000 each; for five years; variable interest rate one point below prime, determined annually. Bank Aristocrat Cash $900 Debt Bldg (B=20 FMV=80) Baker Newco $300 Chef $300 Factors Debt Equity Form Proportionality Debt/Equity Ratio FMV AB 12.85:1) Intent Other (If shareholder debt were subordinated) Conclusion: strong risk of equity given poor debt/equity ratio and proportionality 18

19 Problem 1(b) Interest Paid from Profits p.145 FACTS: Same but each shareholder receives a 10%, 20 year subordinated income debenture. Interest expense is payable only from net profits of the business. Bank Aristocrat Cash $900 Debt Bldg (B=20 FMV=80) Baker Newco $300 Chef $300 Factors Debt Equity Form Proportionality Debt/Equity Ratio FMV AB 12.85:1) Intent? Other (If shareholder debt were subordinated) Conclusion: Equity features dominate. 19

20 Problem 1(c) Guaranteed Loans p.145 $900,000 (additional) loan from the bank; unsecured but personally guaranteed by the shareholders so that shareholders have joint and several for this Bank additional loan. Aristocrat Cash $900 Debt Bldg (B=20 FMV=80) Baker Newco $300 Chef Factors Debt Equity Form Proportionality Debt/Equity Ratio FMV AB 12.85:1) Intent Other (If shareholder debt were subordinated) Conclusion: A strong risk that all the loans, including the Bank loan, are equity under a Plantation Patterns analysis. $300 20

21 Problem 1(d) One Shareholder Lender p.145 FACTS: A (only) loans the $900,000 loan. Five year fixed term. Variable interest rate one point below prime, determined annually. Bank Aristocrat Cash $900 Debt Bldg (B=20 FMV=80) Baker Newco Chef Factors Debt Equity Form Proportionality Debt/Equity Ratio FMV AB 12.85:1) Intent Other (If shareholder debt were subordinated) Conclusion: No proportionality, but still a high debt-equity ratio. Is this instrument really preferred stock? 21

22 FACTS: Same as Problem (d) except that Newco fails to pay interest on the debt. Problem 1(e) Default Two Years Later p.145 Aristocrat Bldg (B=20 FMV=80) Baker Chef Cash Bank $900 Debt Newco Issue: What impact on A s original intent to create a debtor/ creditor relationship? Answer: We look to the facts at the time of the loan and test at that date only, but courts will use the benefit of hindsight to help determine what they think was the original intent of the advance. 22

23 Problem 2 Avoiding Equity Status p.145 Avoiding attributes of hybrid stock: Reasonable interest rate Fixed or floating (reference to external rate) Interest paid with regularity Fixed maturity date No convertibility feature Quite difficult to avoid risk of equity status if: (i) Proportionality and (ii) subordination. 23

24 Character of Gain on Corporate Investment p.146 Equity and debt securities held by investors as capital assets (i.e., not traders) receive capital gains tratement. Special 50 percent exclusion ( 1202) for gain on Qualified Small Business Stock (100% exclusion for investments through 2013 where held for 5 years). Code 1045 gain rollover provision postponement when investment in qualified small business stock. 24

25 Tax Character of a Loss on Corporate Debt Investment p (g)(1) & (2) (worthless securities). Capital loss treatment upon sale or becoming worthless. 166 (bad debt not a security) - Business bad debt as an ordinary loss - Nonbusiness bad debt as a short-term cap. loss Loan to corporation as an employee. Issue re business or nonbusiness bad debt status (i.e., what value of the deduction). See Generes (p.145 n.67) who owned 44 percent of the stock and was part-time president salary $12,000. He advanced funds to the corporation and also guaranteed corporate debts. Court held that Generes dominant motivation was as to make an investment, not to protect his employment status (i.e., his business ). 25

26 Section 1244 Stock Ordinary Loss Deduction p ) Individuals (and partnerships) only. 2) Common or preferred stock issued for money or property, but not for services. 3) Small business. 4) Gross receipts test: requires active business income and not passive income. 5) Annual limit on the ordinary loss amount. No formal Section 1244 plan is required. 26

27 Hi-Tech capital structure for venture capital investment. Problem Alternative Investments p.149 Thelma Allen a) Five year note No participation in equity growth; 166 governs if the note defaults. Nonbusiness bad debt status unless the lender s business is loaning money. b) Registered bond market interest rate. Security categorization under 165(g)(2) & STCL status if held < a year & LTCL if held more than a year. Cash ($400) a) Jennifer $200 Note b) Newco 27

28 Problem (Cont.) p.149 c) Registered bond. Bond loss for a worthless security would be a capital loss per 165(g)(1). Concept of security includes subscription right. Loss on warrants - $10,000 is governed by Code 165(g)(2)(B) & therefore, a $10,000 LTCL if held > 1 year. d) Common stock qualifies as 1244 stock. Ordinary loss treatment available? Yes, for 50K (or 100K, if married). c) Thelma Jennifer d) Cash ($400) Newco C.S. Allen 28

29 e) Convertible preferred stock. Does qualify under Eligibility of up to $50,000 loss (or $100,000 on a joint return) if other requirements are satisfied. Problem (Cont.) Thelma Jennifer e) Cash ($500) Newco Pfd.Stk p.149 Allen f) Original contributions of $500,000 & $500,000. Now, Newco is no longer a small business corporation at the time it issues the additional stock because aggregate amount of money received for original stock exceeds $1 million. Consequently, any loss would not be an ordinary loss, but rather would be a capital loss. 29

30 g) Wedding gift. Donees do not qualify for 1244 treatment. Son is limited to $200,000 capital loss under Code 165(g) (1). Reg (a)-1(b). Only original issuee is eligible for ordinary loss treatment. h) Purchase of stock through a partnership. Partnership is eligible for an ordinary loss deduction under Code Loss will flow through to the eligible partners (not corporations). Problem (Cont.) g) h) Peter Thelma Thelma Gift of Newco C.S Jennifer Cash ($400) Jennifer Cash ($500) Newco Leach Newco C.S C.S p.149 Allen Cash ($400) Peter Allen 30