- Features about the parties formal rights and remedies LEGAL RIGHTS
- What legal rights and remedies in the contract
- Maturity date- usually for fixed term if lender
- Participation in Corporate Gains- Generally associated with equity interests that participate in the corporate adventure, although some debt securities have upside advantage d. Participation in Corporate losses. Debt holders don’t participate
- Certainty of Return – Dividends legally only if the corp has adequate earnings or surplus. Credits have an unconditional right to get the interest on their contract. You pay all the time.
- Remedies upon default- legal- if the company does not pay, the creditors may sue for the amount. Lenders can force debtors into bankruptcy.
- Right to convert debt into stock, at will, then the question will be in what way was this ever really debt? Convertible securities.
- Subordination- Important with bankruptcy, who has the prior claim to the corps earners and assets. Equity holders subordinate. Priority of interest holders
- Voting Control – Equity holders often have voting powers, but it is an equity like feature 2. Facts showing the parties intent?
- What evidence is available to show that the arties want. OBJECTIVE TEST. What the parties are doing at time of deal.
- All the documents surrounding the transaction. Totality of the circumstances will be looked at. Written and Oral Communication.
- What is the document labled? Promissory notes.
- What happens when parties don’t observe the formalities.
- Do the specify the terms of the debt and keep referring to it as debt.
- If the parties are related, does this look like stock that unrelated parties would exchange
- What about the accounting books. Label it correctly in records and balance sheet
- Parties practices matter. If there is purported right to interest, but the corporation never pays the right amount. Irregular paying dividends.
- Paying dividends before interest payments does not look so good either.
- Economic reality of the instruments
- Two important economic factors:
- Do the parties debt interest, mirror the parties equity interests? This raises the possibility that maybe its just equity disguised as debt. Look at proportions.
- Thin Capitalization- Lots of equity
- Debt without much equity looks like an equity investment.
- Look for factors that are pointing more at a corporate adventure.
- What the parties say at the actual time of the dispute – Subjective. How they label it. It counts for something.
- Different taxpayers have different incentives. These factors often matter the most with hybrid securities because they have many different characteristics.
- When does IRS come in? When parties do not negotiate at arms length. The courts are particular skeptical of non- arm lengths negotiations.
Tuesday, May 22, 2012
Four Categories of Features to Show Debt or Equity to Internal Revenue Service (IRS)
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