The war of the MIPS.

In May 1998, the Enron Corporation fried a Tax Court petition contesting the IRS's disallowance of a deduction for interest payments on a monthly income preferred shares (MIPS) transaction. MIPS is a financial product designed to give the overall effect of equity-like treatment for regulatory, rating agency and financial accounting purposes, while providing an interest deduction for tax purposes. However, the Service's position in the Enron deficiency notice apparently did not win IRS National Office support; on Nov. 16, 1998, the Service released Letter Ruling (TAM) 9910046, supporting the taxpayer's treatment of a MIPS transaction. On Dec. 24, 1998, the IRS dropped its challenge to Enron's interest deductions arising from the MIPS securities.

MIPS Transactions

In a typical MIPS arrangement, a parent forms a transparent, wholly owned limited liability company (LLC) or similar passthrough entity. The LLC issues MIPS, which are preferred interests in the LLC, to the public for cash. The LLC then lends the cash from the MIPS sale to the parent, thus creating a related-party loan. The loan and the MIPS generally have identical terms and typically contain a combination of equity and debt features. Equity features include a very long maturity, deep subordination and a holiday of up to five years on the interest payments. Debt features include acceleration of principal payment on default and the right to repayment of the entire principal amount.

Regulators and rating agencies consider the overall effect of a transaction; these agencies conclude that the parent group issued an equity-like instrument. For tax purposes, however, a taxpayer characterizes the transaction in accordance with its form--a sale of a minority interest in an LLC and a related-party debt between the parent and the LLC. The parent takes a deduction for the periodic interest payments made to the LLC on a related-party loan. The LLC makes periodic preferred equity payments to the MIPS holders with the cash it receives from the parent's interest payment. The aggregate amount of preferred equity payments made by the LLC to the MIPS holders normally equals the aggregate interest paid by the parent to the LLC. When the related-party loan from the LLC to the parent matures, the MIPS are redeemed, generally for cash.

MIPS have been a major source of aggravation for the IRS; since MIPS and similar hybrid securities were first approved as equity for balance sheet purposes, taxpayers have issued an estimated $30 billion in MIPS. The Service is concerned about the implications (i.e., lost tax revenues) caused by the disparity between the financial reporting treatment (as equity) and the tax treatment (as debt) in a MIPS transaction. If a parent implements a MIPS transaction in lieu of issuing debt, the IRS is in the same tax revenue position; in either case, the parent receives an interest deduction. However, if the parent implements a MIPS transaction in lieu of issuing preferred shares, it receives an interest deduction in the MIPS arrangement that it would not otherwise receive. Thus, by imposing a transparent LLC to issue MIPS in the transaction, the parent receives an interest deduction for tax purposes and continues to receive equity-like treatment for the transaction for reporting purposes.

After Congress failed to enact legislation that attempted to characterize MIPS as equity for tax purposes, the Enron deficiency notice was the Service's first publicized action to disallow the interest deduction on MIPS arrangements. The arrangements at issue in the Enron case essentially follow the typical MIPS structure. However, the IRS took a new approach in attacking the MIPS arrangement. The deficiency notice determined that the amounts paid by Enron to its LLC (and a partnership) under the related-party loan were not deductible as interest payments, because the related-party loan did not qualify as debt. Enron's deficiency notice stated that the related-party loan did not qualify as debt because the LLC (or the partnership, as the case may be) was controlled by Enron and, as such, the LLC was not able to contract an arm's-length obligation with Enron. The deficiency notice questioned whether an unrelated lender would have made these loans under the same terms and conditions. In effect, the IRS disregarded the LLC (or partnership) and determined that an entity could not make a loan to itself.

This position, however, apparently did not win National Office support. In Letter Ruling (TAM) 9910046, the National Office concluded that loans made between the parent and the LLC were debt for tax purposes. The National Office applied the eight debt-equity factors set forth in Notice 94-47 in analyzing whether the instruments were considered debt or equity for tax purposes:

1. Whether there is an unconditional promise to pay a sum certain on demand or at a fixed maturity date;

2. Whether the holders of the instruments possessed the right to enforce payment of the principal or interest;

3. Whether the instrument holders' rights were subordinate to creditors' rights;

4. Whether the instruments gave the holders the right to participate in the issuer's management;

5. Whether the issuer was thinly capitalized;

6. Whether there was identity between the instrument holders and the issuer's stockholders;

7. The label placed on the instruments by the parties; and

8. Whether the instruments were intended to be treated as debt or equity for nontax purposes (including regulatory, rating agency or financial accounting purposes).

MIPS generally qualify as debt in applying the first seven of these factors in a facts-and-circumstances analysis. (With respect to the seventh factor, many MIPS are now identified as Monthly Income Preferred Securities.) The eighth factor, however, has been a source of contention between tax practitioners and the IRS. The Service has contended that the eighth factor is merely a restatement of the common-law principle that the issuer's intent affects an instrument's treatment for Federal tax purposes. The National Office acknowledged that rating agencies are concerned with a company's financial structure and its degree of financial flexibility, which, generally, is not taken into account for tax purposes. Accordingly, the Service did not find that varying treatment among agencies was a fatal characteristic of the instrument in the case.

The National Office further concluded that, if the preferred securities were treated as issued directly to the public by the parent corporation, they would constitute debt for tax purposes. Although the National Office acknowledged that the LLC was a "tax-transparent" vehicle, it concluded that the interests issued by the LLC would constitute debt if offered directly by the parent. The IRS applied the same debt-equity analysis to the LLC interests as it did when analyzing the loan from the LLC to the parent. Because the loan terms and the LLC interests were virtually identical, it followed that each should be treated consistently for tax purposes. The conclusion will come as a surprise to those practitioners who believed that, if the Service were to disregard the LLC in a MIPS transaction, a corporation would not be entitled to an interest deduction. Rather, the transaction would be treated as though the parent issued its own equity to the investors.

Finally, the National Office determined that the issuance of the preferred securities by the LLC to the public and the subsequent loans from the LLC to the parent have economic substance. The National Office pointed out that the parent formed the LLC to issue securities to public investors and to lend the proceeds from the issuance to the parent. The loans were used for general corporate purposes, including the repayment of outstanding debt. As a result of the repayment of its debt, the parent's overall cost of capital declined. In addition, the parent's debt-to-equity ratio decreased for the period during which the preferred securities were issued. Accordingly, the Service concluded that the transaction had economic substance.

An End to MIPS?

In spite of this taxpayer-favorable ruling, the IRS presumably will continue to seek an avenue to shut down the MIPS advantage. However, the MIPS advantage may be coming to a close. In a Financial Accounting Standards Board (FASB) meeting on Dec. 16, 1998, the board tentatively decided that hybrid preferred securities (such as MIPS) should be treated as debt for reporting purposes. Apparently, this "mezzanine" equity category, which generally consists of instruments that have both debt and equity features but are considered equity for reporting purposes, has recently fallen into disfavor with the FASB. Accordingly, the FASB may turn out to be the Service's white knight in its battle against the MIPS.

FROM MICHELE R. ZINN, J.D., LL.M., WASHINGTON, DC