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CALIFORNIA CORPORATE & SECURITIES LAW

Judge Alex Kozinski On Debt Versus Equity

Judge Alex Kozinski succinctly frames the debt versus equity battle in this opinion issued yesterday:

It’s a timeless and tiresome question of American tax law: Is a transaction debt or equity?  The extremes answer themselves.  The classic equity investment entitles the investor to participate in management and share the (potentially limitless) profits—but only after those holding preferred interests have been paid.  High risk, high reward.  The classic debt instrument, by contrast, entitles an investor to preferred and limited payments for a fixed period.  Low risk, predictable reward.  But a vast hinterland of hybrid financial arrangements lurks in the middle.

Despite the boundless ingenuity of financial engineering, tax law insists on pretending that an instrument is either debt or equity, then treating it accordingly—with sharply different consequences for the taxpayer. A corporation’s interest payments on debt are deductible, for example, while the dividends it pays to equity holders are not.  This black-or white tax treatment gives taxpayers an incentive to conjure up complex instruments that give them the perfect blend of economic and tax benefits. Taxpayer gamesmanship, in turn, puts courts in the ungainly position of casting about for bright lines along an exceedingly cloudy spectrum.

Hewlett-Packard Co. v. Commissioner, 9th Cir. Ct. of Appeals Case No. 14-73048 (Nov. 9, 2017).  This blog isn’t a tax issues blog, so I won’t go into the details of the case.  For those interested in the result, the Ninth Circuit had “no difficulty” in concluding that the investment at issue was debt, a result not desired by the taxpayer.

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