In Hewlett-Packard Co. v Commissioner (TC Memo. 2012-135), the Tax Court recharacterised preferred equity owned by Hewlett-Packard Co (better known as HP) in a Dutch corporation as indebtedness and denied HP foreign tax credits and a capital loss on the exit transaction.
In 1996, HP bought $202 million of preferred shares in Foppingadreef (FOP), an entity incorporated in the Netherlands Antilles. Under the shareholders' agreement, FOP's directors were required to declare dividends on the preferred shares to the extent profits were available to be paid out to HP. Furthermore, HP had the right to put the preferred shares to ABN AMRO Bank, FOP's common shareholder, for their fair market value. In the event that ABN defaulted on its obligation to buy the shares from HP, HP had the right to put the shares back to FOP at fair market value or force FOP to liquidate.
During the course of HP's ownership of the preferred shares, FOP paid foreign taxes which entitled HP as the owner of the preferred shares to take into account foreign tax credits. In 2003, HP put the preferred shares to ABN and claimed a $15.5 million loss on the transaction. The IRS challenged HP's foreign tax credit claim, as well as its exit transaction loss, on three alternative theories: (i) that the stake in FOP was more appropriately characterised as debt, and not equity; (ii) that the investment was a sham under the economic substance doctrine; and (iii) that, under the step transaction doctrine, FOP was a conduit for a loan from HP to ABN. Tax Court Judge Joseph Goeke's decision that the FOP investment was more akin to a loan than an equity interest mooted the latter two issues.
The Tax Court applied the Ninth Circuit's 11-factor test for characterising debt versus equity. In order to analyse the instrument, the Tax Court first considered whether or not HP's put option should be integrated with the investment. HP argued that the put option should not be integrated because it was not binding on FOP, but rather on FOP's common shareholder, ABN. The Tax Court disregarded this distinction, finding that the put option was part of a package of agreements signed at the FOP closing, that the put option was referenced in the shareholder agreement, and that FOP was inextricably connected to the exercise of the put option.
In applying the 11-factor test to the integrated investment, the Tax Court spent considerable time addressing whether the instrument contained a fixed maturity date and whether HP was afforded creditor's rights. Although HP argued that the presence of a put option should not be construed as a maturity date, the Tax Court found that all parties expected HP to exit the transaction through the put option in 2003. Additionally, "FOP's articles of incorporation and various agreements pertaining to FOP afforded HP an apparatus to enforce creditor rights".
The Tax Court also found that even though HP was nominally entitled to receive dividends from FOP's earnings, indicating an equity interest, the earnings of FOP were predetermined, "assuring that FOP would have sufficient earnings to make the agreed periodic payments to HP". As to whether or not HP enjoyed management rights in FOP, the court held that HP did not value those rights, and therefore, the court would "ascribe the same weight to HP's objectively meaningful voting rights as it did over the term of the transaction".
Finally, the Tax Court found that although HP was nominally subordinated to all claims of indebtedness against FOP, FOP was prohibited from having material creditors, and therefore, "HP's rights would never be subordinated to any creditor's".
The Tax Court then turned to whether the loss HP incurred upon exiting the transaction should be disallowed. The court suggested that the $15 million decline in value on the investment represented a fee for participation in a tax shelter. Because HP could not carry its burden of showing that this fee should be deductible, the court disallowed the loss on the transaction.
Thomas A Humphreys, Remmelt A Reigersman and Jared B Goldberger