Debt or equity? New pathways - another dead end or the yellow brick road?
The Omnibus Budget and Reconciliation Act of 1989 intensely examined the debt-equity conundrum and adopted some creative new pathways to deal with it. First, Congress developed irrebuttable presumptions to distinguish debt from equity in connection with the provisions dealing with high-yield discount debentures and earnings stripping. Second, a system of bifurcation, for limited purposes, was devised for certain high-yield discount debentures, with the Department of the Treasury being given the green light to bifurcate other obligations into debt and equity components. This article summarizes the new rules and analyzes the implications.
High-Yield Discounts Bonds
Tax and economic policy prompted Congress to make a rather prophetic statement on leverage. Concerned about certain high-yield bonds - particularly those calling for interest to be paid with additional debt(1) - the House Committee on Ways and Means concluded that certain high-yield bonds "resemble equity for tax purposes" and, further, that the availability of the interest deduction for such instruments was resulting in "highly leveraged corporate financial structures that impose an undesirable level of risk on investors and the economy."(2)
As a result, important new debt-equity "safe harbor" rules were adopted. Surprisingly, the rules are not limited to leveraged acquisitions; for example, they may apply to high-yield debt issued by high-tech ventures or real estate enterpreneurs, if they operate through a corporate vehicle.
B. The Basic Bifurcation Rule
Believing that a "portion of the return on certain high-yield OID obligations is similar to a distribution of corporate earnings,"(3) the House-Senate conferees decided to enact new section 163(e)(5) of the Internal Revenue Code. The new provision bifurcates the yield on an "applicable high yield discount obligation," so that -
* an interest element of up to 6 points over the applicable federal rate (AFR) will be deductible only when paid (which will not include "payments" in stock or debt), and
* the excess over 6 points will be treated as a return on equity for which no deduction can ever be had, but for which a dividends-received deduction (DRD) is allowable.
Congress "split the baby" heavily in favor of debt in that (1) the applicable obligation remains a debt instrument for all purposes of the Code, and (2) the portion of the yield that is deemed to be a dividend is treated as such only for purposes of the DRD. Although the new rule can hardly be characterized as "simplification," this split stands as an ingenuous way of legislating the bifurcation principle while avoiding the severe complexity inherent in the House bill.(4)
The following two examples from the Conference Report illustrate the basic bifurcation rule:(5)
Example 1. - Assume a corporation issues an applicable instrument at the beginning of the year with an issue price of $100 and a yield to maturity of 20 percent in a month when the AFR is 9 percent. The AFR plus 6 percentage points is 15 percent. The return on the instrument in the first year is $20 ($100 issue price times the 20-percent yield to maturity) and the adjusted issue price is $120 at the end of the year. The return on the instrument in the second year is $24 ($120 adjusted issue price times the 20-percent yield to maturity). The ratio of the disallowed portion of the yield to the yield is 25 percent (20-percent yield to maturity minus 15 percent) divided by 20-percent yield to maturity). The amount of the disqualified portion in the first year is $5 ($20 return for the year times 25 percent). The ratio of the disallowed portion of the yield to the yield is constant throughout the term of the instrument (in this case, 25 percent). Thus, the disallowed portion in the second year is $6 ($24 return for the year times 25 percent).
The allocation of payments of OID made under a debt instrument before maturity between the disqualified portion and the remainder is to be made pursuant to Treasury regulations. The Conferees expect such regulations to provide that such payments will be allocated on a pro rata basis between accrued but unpaid OID treated as interest, and the accrued but unpaid disqualified portion of the OID.
Example 2. - Assume the same facts as in Example 1 above. If the issuer distributes, in cash, $12 with respect to the instrument at the end of the second year, $3 ($12 times 25 percent) will be considered to be a payment of the accrued but unpaid disqualified portion, and the issuer will be allowed a deduction of $9 ($12 minus $3).
C. Defining "Applicable Obligations"
An "applicable high yield discount obligation" is a debt instrument issued by a corporation that satisfies three tests:
* Long term: Its maturity date must exceed five years.
* High yield: The yield to maturity must equal or exceed the AFR (for the month of issue) plus five percentage points. Thus, assuming a 10-year maturity, annual compounding, and issuance in January 1990, the yield to maturity must equal or exceed 13.02 percent (AFR of 8.02% + 5%).
* Significant OID: Beginning on the 1st accrual period ending after 5 years, and for each accrual period thereafter, the instrument cannot call for the deferral of more than the first year's interest. In general, this rule will catch all debt that is PIK for more than one year.(6)
D. Two Important Tax Policy Achievements
1. Distillation of the debt-equity rules. The foregoing three tests are, in substance, a distillation of the 13 (more or less) factors that the courts have slavishly played around with - before announcing what they felt in their gut was the right answer all along. The three tests are targeted at the ultimate economic question: whether the funds have been placed at the risk of the venture, or stated slightly differently, is there a reasonable expectation of payment regardless of the success of the business? In the case of an applicable obligation, the statute irrebuttably presumes that the funds are at the risk of the business based on the objective facts that the instrument is both long term and high yield and the interest payments are deferred.(7)
2. Dual aspect of debt instrument legislated. Another and perhaps more significant achievement is that the Congress codified the principle that a single debt instrument can reflect both a cost of capital (interest) and an equity return (dividend). This may beget other changes.(8)
E. Some Additional Statutory Details
and Technical and Policy Issues
1. Regulatory authority. The 1989 Act puts the spotlight on a host of technical issues, and leaves them to forthcoming regulations:
REGULATIONS. - The Secretary shall prescribe
such regulations as may be appropriate to carry out
the purposes of this subsection and subsection (e)(5),
(A) regulations providing for modifications to the
provisions of this subsection and subsection (e)(5) in
the case of varying rates of interest, put or call
options, indefinite maturities, contingent payments,
assumptions of debt instruments, conversion rights,
or other circumstances where such modifications are
appropriate to carry out the purposes of this subsection
and subsection (e)(5), and
(B) regulations to prevent avoidance of the purposes
of this subsection and subsection (e)(5) through
the use of issuers other than C corporations, agreements
to borrow amounts due under the debt instrument,
or other arrangements.
2. Legislative history. The Committee Reports(9) state that the conferees "expect" that the implementing regulations will adopt the following rules:
i. Variable interest. For debt that calls for a variable rate of interest, taxpayers should assume debt provides for a "fixed interest rate corresponding to the rate established by the variable rate [within the meaning of Prop. Reg. [subsections] 1.1275-5] on the issue date."
ii. Contingent interest. The taxpayer should "take into account the expected amount of any contingent payment" in determining whether the obligation is an applicable obligation.(10)
iii. Borrowing to pay interest. The Treasury Department should address - perhaps even on a retroactive basis - situations in which an applicable obligation may be effectively involved if the taxpayer has issued an obligation bearing stated interest "while entering an agreement to borrow amounts to pay such interest."
iv. Convertible debt. The Treasury Department may "include modifications in the case of conversion rights." In addition, "for purposes of determining the maturity of an obligation, such regulation would provide that the right to convert... may be disregarded if such right is solely in the hands of the holder and the exercise price is the fair market value, at the date of conversion, of the... stock...." (Emphasis added.)
v. Collateralized debt. The regulations may treat debt as an applicable obligation if the corporation that issues such debt also "participates" in the collateralization of obligation if issued by a corporation.
3. Determining the disqualified portion and the dividend equivalent portion. Generally, no deduction is allowed for the "disqualified portion" of the yield, which is the lesser of (i) the OID, or (ii) an amount computed under the following formula:
Disqualified Yield (amount in excess of 6 points over AFR)/Yield to Maturity X Total return (which includes QPIP)
Examples of the foregoing formula are set forth in the Conference Report and are quoted earlier in this article.
The amount of the "disqualified portion" that is eligible for the DRD is called the "dividend equivalent portion" and is generally equal to the disqualified portion of the OID which would have been treated as a dividend had a distribution of such amount been made by the issuing corporation with respect to its stock.
A special rule (set forth in section 163(e)(5)(E) provides that earnings and profits (E&P) are to be computed without regard to the new rules. Thus, E&P will be reduced for the OID accrued, regardless of when the interest is paid (assuming the taxpayer is on the accrual method). The one exception is that no reduction in E&P is made for the disqualified portion in determining whether the disqualified portion would have been a dividend for the taxable year in which distributed. Stated differently, since available E&P is normally determined before the payment of a dividend to determine whether the distribution is a return of capital or a dividend, the disqualified portion will be similarly treated.
4. Effect on basis adjustments, withholding requirements, etc. If the disqualified portion of a payment is really like a dividend, and is subject to the DRD, query why it is not also subject to section 1059 (related to basis reduction for extraordinary dividends), a basis reduction under section 301(c)(3)(A) if there is insufficient earnings and profits, or to dividend withholding and reporting requirements. The statute appears to preclude the application of such correlative events since the dividend equivalent is treated as a dividend "[s]olely for purposes of sections 243, 245, 246, and 245A."
5. The asymmetrical treatment of the issuer and holder. The drafters of the legislation were at first reluctant to suggest that the holder had to accrue income, while the issuer would be required to wait for its deduction until the interest was paid. This was a theoretical deviation from the symmetrical OID rules that, at long last, "seemed to be working." There was a concern that a deviation from that principle might cause the OID system to unravel.
Since many of the holders of PIK or deep discount bonds are tax-exempt pension trust or foreign holders, however, no one is likely to complain about the lack of symmetry in view of the fact that the OID accrual otherwise is a tax-neutral event. In addition, there is precedent for this asymmetrical approach. See I.R.C. [subsections] 163(e)(3) (no deduction for OID until paid where instruments are issued by a related foreign lender) and [subsections] 1275(b)(2) (no deduction for OID loans to finance personal-use property).
6. Pass-through entities. A specific rule (set forth in section 163(e)(5)(D) exempts any obligation issued by an S corporation. The statute grants the Treasury Department regulatory authority to deal with debt issued by "issuers other than C corporations" (e.g., partnerships owned in whole or in part by C corporations). If Treasury does not deal with debt issued by partnerships, the Congress may have added another powerful impetus for the "Partnerization of America."
F. Effective Date Issues
The new rules are generally effective for instruments issued after July 10, 1989. Note that this is the date of the House announcement, even though the provisions were substantially revised by the House-Senate Conference. Moreover, the grandfather rules are, in general, drawn very narrowly.
The major grandfather exceptions are for (i) obligations to issue PIK bonds, (ii) refinancings, (iii) binding contracts, and (iv) convertible preferred stock.
Specifically, the rules do not apply in respect of PIK bonds issued pursuant to the terms of a debt instrument issued on or before July 10, 1989. Similarly, they do not apply to refinancings of grandfathered debentures, so long as the refinancing does not -
(a) postpone the maturity date or the interest payment
dates of the original debenture,
(b) result in an issue price above the original
debenture's adjusted issue price,
(c) increase the stated redemption price at maturity of
the original debenture, or
(d) decrease the interest payments before maturity required
under the original debenture.
The policy basis for this last requirement is unclear and it would seem to undercut the ability of debtors to reduce their total debt obligations in connection with a workout. This result would seem to be at odds with the policy objective of reducing excessive leverage.
An unusually restrictive set of binding contract rules were adopted to deal with instruments "issued in connection with an acquisition," including a provision that requires that the pertinent documents specify the term, and if not, 10 years will be the maximum term. Another provision requires that the maximum amount of the proceeds must "be determined" on or before July 10, 1989. The dictionary definition of "determined" is very tight - "to fix conclusively." Such determination must be evidenced by written documents transmitted between the issuer and governmental regulatory bodies or "prospective parties" to the issuance.
Finally, footnote 26 in the Senate Report(11) takes the position that debt issued as a result of a conversion by the issuer of preferred stock into an applicable obligation is not grandfathered - even if the convertible stock was outstanding on July 10, 1989, and the terms of the applicable obligation were set in stone. Although this result is terribly unfair, apparently this is the way the revenue estimate was "priced."
G. Possible Ways to Live With the New Rules
1. Balloon interest payments before first testing date. The statute tests whether there will be significant OID when the debt is issued. It also allows an issuer to play catch-up by sanctioning a more-than-one year interest deferral as long as the maximum one-year deferral test is met on the first (and subsequent) testing date. Consequently, instruments calling for balloon interest payments that would cause the instrument to meet the one-year test clearly should work.(12)
At least one transaction already used this technique. In the Container Corporation of America/Jefferson Smurfit transaction, interest on the Junior Accrued Debentures will accrue on December 1, 1994, at which time the interest will be payable in full. For the balance of the 15-year term, interest will be payable in cash on a semi-annual basis.
Although the balloon payment in this transaction comes after five years, an even later balloon payment could work. For example, if a bond were issued at face and called for annual compounding, the balloon interest payment could be paid 5 years and 365 days after the issuance of the debt.
What is the result if there is no reasonable possibility that the issuer will be able to meet the balloon payment? Presumably this is not an issue under section 163(e); rather, it should be factored into the basic debt-equity analysis, on which the taxpayer has to pass muster before dealing with section 163(e).
2. Short-term debt intended to be refinanced. In view of the Treasury Department's regulatory authority to deal with "agreements to borrow amounts due under the debt," a binding agreement to refinance, for example, a 4-year note with a 7-year note, will likely be treated as a single 11-year note. What if the agreement is not binding, but rather is a mere "understanding," subjecting the issuer to the risks of the market? Will a step-transaction analysis (such as the end-result test) have to be dealt with? The current inclination of government officials is to aggregate only in situations involving binding contracts.
3. Borrowing or overfunding to pay interest. What if the issuer borrows to pay current interest? Preliminary indications from government officials suggest that such borrowings will not turn the instrument into an applicable obligation if the additional borrowing is from an unrelated lender. If such additional borrowing were not acceptable, it would be nearly impossible to determine when an interest obligation should be considered paid from other outstanding debt, rather than from earnings or other sources.
4. Convertible debentures. A conversion feature integrated with a debt instrument (i.e., a convertible or exchangeable debt) will obviously require a lower yield and may well cause the instrument to fail the significant OID test. Although the statute grants the Treasury regulatory authority to deal with "conversion rights," preliminary reaction from government officials is that a "conventional" convertible or exchangeable debt instrument will be respected and will not be separated into a debt and option component. If the Treasury were to bifurcate "plain vanilla" convertibles into a debt instrument and a warrant, there could be serious repercussions in many areas, including OID and reorganizations.
Limitation on Deduction for
Earnings Stripping Payments to
Related Tax-Exempt Persons
New section 167(j) of the Internal Revenue Code is aimed at what is commonly referred to as "earnings stripping." The technique generally involves "aggressive" borrowings by a U.S. subsidiary from its foreign parent. Both companies may benefit by characterizing the instrument as debt: generally, the interest is deductible to the issuer and, if a treaty applies, either is not taxable to the foreign parent or is subject to a reduced rate of withholding. Congressional concern about this situation was expressed as follows:
Allowance of unlimited deductions for related party interest permits an economic unit that consists of more than one legal entity to contract with itself at the expense of the government.(14)
B. An Outline of the Mechanics
Under section 163(j), no current deduction is allowed for interest paid or accrued to a foreign lender or a tax-exempt organization if the following four conditions are met:
1. The borrower is a corporation related to the lender
within the meaning of section 267(b) or 707(b)(1)(15)
(generally a more than 50-percent ownership interest).
2. No U.S. tax is imposed on the interest received (or
a reduced tax rate is imposed as a result of a
3. Net interest expense exceeds 50 percent of adjusted
taxable income (actually more like a cash
flow or EBDIT [earnings before depreciation, interest,
and taxes] concept than a taxable income
concept),(16) plus a carryover of any unused limitation
from the prior three years.
4. The ratio of debt to equity as of the close of the
taxable year exceeds 1.5 to 1.
Any amount not currently deductible under such rules may be carried forward indefinitely and can be used in any year in which the last two tests are met.
C. Additional Statutory Details and Technical and
Policy Issues Related to the Debt-Equity Test
1. The statutory definition. Section 163(j)(2)(C) defines the debt-equity ratio as "the ration which the total indebtedness of the corporation bears to the sum of its money and all other assets less such total indebtedness." Three special rules are added: (a) the value of the equity shall include the tax basis of the assets (and not, as normal in a debt-equity analysis, the fair market value of the assets);17 (b) the issue price of debt, plus accrued OID, shall control; and (c) all members of an affiliated group "shall be treated as 1 taxpayer."18
2. Unusually broad regulatory authority. The statute also provides that "there shall be such other adjustments as the Secretary may be regulations prescribe." The Conference Report (i) notes the "complexity" of the legal issues, (ii) grants regulatory authority to make adjustments "so that the application of the statute will be consistent with the concept of thin capitalization," and (iii) invites the Treasury Department to report to Congress if its regulatory authority is viewed as inadequate, so Congress can fix the statute.19
3. The guarantee issue. A foreign parent corporation will often provide its guarantee of a debt of its subsidiary held by a third party as a means of lowering the effective cost of borrowing. Under current law, such borrowings could under certain circumstances be transformed into a loan to the parent, which is then treated as a contribution to the capital of the subsidiary. If such a loan were recast by the IRS as a loan to the parent and then a loan from the parent to the subsidiary, it would set the stage for the possible application of the earnings stripping provisions. The Conference Report tempers a broader statement in the House Report by noting that "a guarantee given in the ordinary course" should not "generally" be recast.20 Guaranteed third - party debt and back-to-back loans used as a "device for avoiding the operation of the earnings stripping rules," however, would not be protected. Finally, citing Plantation Patterns Inc. v. Commissioner,21 the Conference Report states that the Treasury is free to use current law to recast guaranteed loans.22 Should new regulations "depart" from current law, however, existing guaranteed debt is to be grandfathered.
4. Rationale for debt-equity ratio and 50-percent rule. The debt-equity test was added in by the conferees and serves two purposes. First, it simplifies the provision in that many corporation will automatically be excluded from the earnings stripping rules.23 Further, it buttresses the argument that the real targets for the legislation are those that are abusing a basic tax tenet - the line between debt and equity - and the provision is not a discriminatory attempt to bash foreign interests who are buying-up America.
The 50-percent rule could be viewed as a safe harbor (for government). The theory would be that any instrument (or group of instruments) that captures more than 50-percent of the adjusted taxable income of the issuer may well be a disguised form of equity.
In effect, the earnings stripping rules constitute yet another distillation process. This time the 13 (more or less) factors have been reduced to only 2 - one a time-honored test (debt-equity) together with a new kid on the block (a percentage of income captured).24
Bifurcation Authority and Other
Congressional Advice Under Section 385
A. Amendment to Section 385
Although the Treasury Department apparently did not ask for it, nor need it,25 Congress "clarified" section 385(a) of the Code. Before the amendment, the Secretary was authorized to prescribed regulations to determine whether an interest in a corporation is "stock or indebtedness." The additional authority allows the Secretary to determine whether the interest "is part stock and in part indebtedness."
B. Effective Date
Although the statute provides that any new regulation dealing with bifurcation can only be applied on a prospective basis, it goes on to redefine the normal concept by providing that the prospective requirement will be met if taxpayers are notified of any such bifurcation regulation through a "regulation, ruling or otherwise."
Interestingly, the Senate Report seems to leave the door ajar for retroactive, nonregulatory bifurcation. Both the House and Senate Reports state:
Some cases, however, have treated certain instruments
as part debt and part equity. See, e.g., Farley
Realty Corporation v. Commissioner, 279 F.2d 701
(2d Cir. 1960).26
The Senate Report (and not the House Report) ominously declares that "[n]o inference is intended that the Internal Revenue Service cannot characterize an instrument as part debt and part equity under present law."27
C. Some Congressional Debt-Equity Advice
1. Suggested bifurcation targets. As examples of instruments having significant debt and equity characteristics, both the House and Senate Reports suggest that bifurcation -
may be appropriate in circumstances where a debt
instrument provides for payments that are dependent
to a significant extent (whether in whole or in
part) on corporate performance, whether through
equity kickers, contingent interest, significant deferral
of payment, subordination, or an interest rate
sufficiently high to suggest a significant risk of default.28
2. Continued authority for debt-equity regulations; and please, more rulings. Although "not required," the House and Senate Reports advise the Treasury that it "will continue to be authorized" to issue comprehensive debt-equity regulations under section 385. Beyond that, the Treasury is "directed to increase the issuance of IRS published rulings on debt-equity issues."29
D. Will Treasury Dance?
The open question is whether Treasury will accept the congressional invitation to bifurcate. The complexity bifurcation adds to the administration of the tax laws was catalogued for the Congress and the Treasury in connection with the rejected House proposal (which would have treated certain high-yield discount debt instruments as equity for all purposes of the Code).30
While the legislative history seems to favor bifurcation, Treasury is actively pursuing simplification. It is doubtful if the two can co-exist. Query whether the Treasury Department, on the grounds of simplicity, will adopt the simplified bifurcation pathway as Congress did with respect to applicable obligations.
Congress has constructed a variety of new pathways to deal with the seemingly intractable debt-equity issue. No single new path offers a complete solution at the present time, but it does appear that with another intense effort a workable solution may be just down the road.
Footnotes - Debt or Equity? New Pathways
(1) A bond received as payment of interest is known as a "baby bond" or a "pay-in-kind" (PIK) bond. From a tax standpoint, there is virtually no difference between a PIK and a zero coupon note. A number of business reasons, however, caused PIKs to become the preferred instrument. (2) H.R. Rep. No. 101-247, 101st Cong., 1st Sess. 1220 (1989) (hereinafter referred to as "House Report"). (3) H.R. Rep. No. 101-386, 101st Cong., 1st Sess. 553 (1989) (hereinafter referred to "Conference Report"). (4) The final bill represents a compromise between the House bill (which treated the targeted instruments as preferred stock for all purposes), and the Senate bill (which simply deferred the interest deduction until paid). (5) Conference Report at 554. (6) Basing the determination of significant OID strictly on the proposed regulations under section 1273 would threaten several instruments that are in fact current-pay instruments (and thus outside the intended reach of the new legislation) but that may be treated as having significant OID because of the very narrow definition of qualified periodic interest payments (QPIP) test under Prop. Reg. [subsection] 1.1273-1(b)(1)(ii) (e.g., instruments which rely on multiple indices). See Letter from Benjamin J. Cohen and Richard L. Reinhold to Thomas Wessel and Robert Scarborough, Highlights and Documents 991 (February 2, 1990), suggesting that "interest that is paid not later than the close of the accrual period in which it accrues" should be excluded from the definition of OID for purposes of section 163(e)(5)(A)(i). For a detailed analysis of the technical morass that will confront taxpayers under section 163(e)(5), see Levin & Gallagher, New Code Section 163(e)(5) Limiting Deductibility of Interest on OID and PIK Debentures, Tax Notes 555 (January 29, 1990). (7) Members of the staff of the Joint Committee on Taxation have suggested that the high-yield aspect of the obligation is the wrap-around test and builds in a cost factor for any other items related to risk, such as subordination. (8) See Kleinbard, Beyond Good and Evil Debt (And Debt Hedges): A Cost of Capital Allowance System, 42 Taxes 943 (1989). (9) House Report at 1223-24; S. Print No. 101-, 101st Cong., 1st Sess. 54 (1989) (hereinafter referred to "Senate Report"); Conference Report at 548. (10) It is not clear if such contingent interest amount should be taken into account for purpose of determining yield to maturity or the presence of significant OID or both. Preliminary reaction by government officials is that contingent interest should affect only the yield issue. (11) Senate Report at 56 n.26. (12) Note that a balloon interest payment might be difficult to negotiate if the senior lenders were counting on the funds from the interest holiday to insure the retirement of their debt holdings. (13) The purpose of including this topic in this outline is to explore the debt/equity ramifications of the proposal. Treaty and other implications are left for another day. (14) Conference Report at 568. (15) A special exception from the rule applies to payments to a related partnership if partners with respect to whom no U.S. tax is imposed own less than 10 percent of the partnership. (16) Adjusted taxable income is computed without regard to: (1) net interest expense; (2) net operating loss; and (3) deductions for depreciation and amortization. (17) The statute refers to the tax basis "for purpose of determining gain." Presumably, this formulation is designed to make sure the anti-Woods adjustment to stock basis was taken into account since it only applies "solely for purposes of determining gain or loss." See I.R.C. [subsection] 1503(e)(1). But see note 18 infra. (18) Does this single entity assumption mean that the basis of the stock in any subsidiary will be ignored, and only the inside basis of the assets of the subsidiary will be taken into account? This may be quite unfair if P pays a significant premium for the stock of Target and (as is likely) no section 338 election is made. (19) Conference Report at 570. (20) Conference Report at 566. (21) 462 F.2d 712 (5th Cir.), cert. denied, 409 U.S. 1076 (1972). (22) Conference Report at 567. The puzzling point is that the proper recast on the deemed transfer of the funds from the parent to the subsidiary is a contribution to capital, not a loan. That is the result in Plantation Patterns, the only case cited by the Conference Report. Under this traditional recast, while the subsidiary's interest expense would be totally disallowed, other interest paid to the exempt holders might qualify under section 163(j) since the subsidiary's debt-equity ratio has improved, etc. (23) Congress apparently thought it was adopting a generous safe harbor test. "For example, the Conferees expect that the interest deductions of many corporations will not be affected . . . because many corporations with what can fairly be called typical capital structures have debt-equity ratios below the safe harbor ratio in the bill." Conference Report at 567. The Conference Report continues that the "median debt-equity ratio for U.S. corporations is generally measured as less than 1.5 to 1." Conference Report at 567. Compare this "generous" ratio with the withdrawn section 385 regulations which provided that a corporation would not be considered to have "excessive debt" as of the end of the taxable year on which the debt was issued, if the issuer had an "outside" debt-equity ratio of not more than 101:1 and an "inside" ratio of not more than 3:1. (24) While the debt-equity ratio factor has generally been thought to have lost its punch, Congress appears to be revitalizing it. For a review of the rise and fall of the importance of the ratio test, see Caplin, The Caloric Count of Thin Incorporation, 17 N.Y.U. Institute on Federal Taxation 771 (1959). Judge Tuttle put the case for the primacy of the intention test most forcefully: "If they make such a determination and it is clear that [indebtedness] is their intent, the fact that . . . this leaves them in a position to enjoy more favorable deduction privileges than if they had put it all in as capital . . . does not entitle the Commissioner of Internal Revenue to rewrite their balance sheet for them and show to be capital what was intended to be a loan." Rowan v. United States, 219 F.2d 51 (5th Cir. 1955). (25) The section 385 proposed regulations did, in fact, bifurcate. "The proposed regulation provides . . . rules under which certain interests are treated as either indebtedness, equity, or a combination of the two." Preamble to Proposed Regulations under Section 385 (filed March 20, 1980). (26) House Report at 1236; Senate Report at 65. The Farley case has been criticized by at least one commentator. See Feder, "Either a Partner or a Lender Be: Emerging Tax Issues in Real Estate Finance," 36 Tax Lawyer 191, 207-10 (1983). (27) Senate Report at 66 . (28) House Report at 1236; Senate Report at 66. (29) House Report at 1236; see Senate Report at 66. (30) See Report of the New York State Bar Association on the Revenue Reconciliation Act of 1989, at 16-26 (September 19, 1989); Levin & Gallagher, Proposed Code Section 386 Treating OID and PIK Debentures As Preferred Stock, Tax Notes 97 (October 10, 1989). (*) The author wishes to thank Joseph D. Sullivan, an associate at Latham & Watkins, who made a valuable contribution to the article.
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