Laidlaw Taxpayer Crashed and Burned, Losing Billion-Dollar Debt-Equity Case
Be careful what you say -- you may have to live with it! Inconsistent statements to Canadian authorities haunt US subsidiary.
Some opinions seem to travel a tortured path but still reach a reasonable result. This may have been the case in the recent Tax Court decision of Laidlaw Transportation, Inc. v. Commissioner.(1) Although only a memorandum decision of the Tax Court -- a type of decision that is not even supposed to be cited as precedent in the Tax Court itself -- the case has already attracted a great deal of attention from and caused a great deal of concern among Canadian and other foreign multinational enterprises and their tax advisers.
Laidlaw Transportation Ltd. ("Canadian Parent") was a publicly-traded corporation that, through its subsidiaries, had international interests in bus transportation and waste disposal businesses. During the taxable years at issue (1985-1988), Canadian Parent went on an acquisition spree in the US market in order to expand its presence in these industries. This required a substantial capital infusion, which took the form of nearly US$1 billion in intercompany loans. The ultimate issue addressed by the Tax Court in Laidlaw was the characterization of these intercompany loans as debt or as equity, which in turn determined the ability of Canadian Parent's US subsidiaries to deduct over US$130 million in interest payments that had been made pursuant to these loans.(2)
From 1969 through the mid-1980's, the Laidlaw corporate group expanded rapidly through the acquisition of a variety of privately held businesses that provided bus transportation or waste disposal services. To gain an advantage over its competitors in purchasing US businesses in these industries, the Laidlaw corporate group, on the advice of its accountants, established in the fall of 1985 a fairly common cross-border intercompany loan structure to finance its acquisitions, with the goal of obtaining the benefit of interest deductions in both Canada and the United States. This structure involved the creation of a new Canadian subsidiary ("Canadian Finance Company"), which in turn created a Netherlands subsidiary ("Dutch Lender") to make loans to the non-Canadian subsidiaries of Canadian Parent, including its US subsidiaries. It was intended that (1) Canadian Parent would borrow funds from an institutional lender (e.g., a Canadian bank), (2) Canadian Parent would contribute those funds to the capital of Canadian Finance Company, and (3) Canadian Finance Company would use the funds to capitalize Dutch Lender with a combination of equity and interest-free loans (which were generally treated as equity in the Netherlands).
The loan agreements between Dutch Lender and the US subsidiaries originally included fixed maturity dates, guarantees of parent companies, fixed interest rates (generally based on the commercial bank prime rate or LIBOR plus a fixed number of basis points), and lender covenants (e.g., a requirement that the borrower maintain a debt-equity ratio no greater than 2.5:1). The loan agreements also provided for "balloon" payments of principal at maturity, and some of the loan agreements permitted the borrower to extend the term of the loan for five years. (In the event of term extensions, the loan agreements required self-amortizing payments of principal, and Dutch Lender retained the right to demand repayment at any time.)
In October 1986, the Laidlaw corporate group acquired GSX Corporation ("GSX"), a US solid waste disposal services business, for US$350 million. To investigate the possibility of obtaining external financing for this acquisition, two of the principals of the Laidlaw corporate group approached three investment banks. Each of these investment banks proposed financing the GSX acquisition with some combination of newly issued and publicly traded equity or convertible debt, subordinated debt, and bank loans. The Laidlaw corporate group did not pursue these proposals, however, for three reasons: Dutch Lender could provide financing on more favorable terms than a commercial lender, GSX did not have the audited financial statements necessary for a public offering, and a public offering would dilute the ownership of the US subsidiaries. The Laidlaw corporate group thus made the GSX acquisition wholly with funds borrowed from Dutch Lender.
As a result of this acquisition strategy, however, the US subsidiaries' exceeded the limits on their debt-equity ratios provided in covenants in their existing commercial bank loans. Therefore, shortly after the GSX acquisition, Dutch Lender was informed by one of the principals of the Laidlaw corporate group that its loans would be subordinated to the U.S. subsidiaries' commercial bank loans. Accordingly, Dutch Lender amended all of its outstanding loan agreements with its US affiliates, effective as of September 1, 1986. This amendment (1) provided that all amounts due on the outstanding loans would be payable on demand; (2) set the interest rate on these loans at prime plus 2%; (3) eliminated financial ratio covenants in the loan agreements; (4) subordinated Dutch Lender's loans to the commercial bank loans of the US affiliated borrowers; and (5) provided that Dutch Lender would advance further sums on request, subject only to the availability of funds.
In July 1987, the US subsidiaries once again entered into new loan agreements with Dutch Lender. These loan agreements contained the same terms as the agreements dated as of September 1, 1986, except that the loans were changed from demand loans to term loans with a maturity date of September 1, 1989 (unless extended by written agreement), and certain enforcement provisions (including an acceleration clause) were added to the agreements.
Apparently, none of the US subsidiaries repaid any principal during the years at issue, and the due dates for principal payments under the loans were routinely extended. In addition, during the years at issue, Dutch Lender made further advances to its US affiliates in amounts sufficient to fund more than 90% of the interest payments required to be made to Dutch Lender under the intercompany loan agreements.
On audit, the Internal Revenue Service (IRS) challenged the loans from Dutch Lender to its US affiliates, and disallowed over US$133.5 million in interest deductions claimed by those US taxpayers, on the ground that the loans were equity in substance. The Tax Court agreed with the IRS, and sustained the deficiency against the US subsidiaries.
Tax Court Decision
In determining whether the intercompany loans constituted debt or equity, the Tax Court evaluated 13 factors used in a prior case by the federal circuit court of appeals, that would hear any appeal by the US taxpayers in Laidlaw, as well as 3 additional factors suggested by the US taxpayers. The Tax Court found that each of these factors either favored characterization of the intercompany loans as equity rather than debt or was neutral.
Although the Tax Court acknowledged that the label on an instrument (here, debt) was usually a favorable factor for debt characterization, it gave the label almost no weight in Laidlaw because the lender and borrowers were related and were under common control. The Tax Court found the following factors to be indicative of equity rather than debt:
- the repeated extension of maturity dates;
- the lack of an expectation of repayment;
- the lack of an intention to request repayment;
- the changing of term loans to demand loans (in the agreements dated as of September 1, 1986, mentioned above);
- the circular flow of funds (that is, the making of advances to cover most of the interest payments);
- the high debt-equity ratios of the US subsidiaries as compared with those of their competitors';
- the US subsidiaries' inability to obtain an equal amount of debt from unrelated lenders, as demonstrated by the investment banks' proposals for financing the GSX acquisition (each of which contemplated partial equity financing); and
- the fact that in an audit of Canadian Parent by Revenue Canada, Canadian Parent had made statements that it had acted as a "conduit in providing funds for its operating subsidiaries" and that "[t]he loans are in the nature of capital contributions to the subsidiaries."(3)
Cause For Concern?
The Tax Court's decision in Laidlaw has caused concern among multinational enterprises and their tax advisers. At its crux, this concern appears to relate to the extent to which the analysis of the Tax Court in Laidlaw may be applied to other US borrowers.
As a conceptual matter, the applicability of Laidlaw to other taxpayers should be limited. By their very nature, debt-equity cases are decided on the basis of the specific facts and circumstances presented to the court. The formulation of general standards (from any one case, or even a number of cases) is complicated by the application of the numerous factors that have been identified by the courts as relevant to the debt-equity inquiry, because, in general, none of these factors is considered controlling and the factors are not given equal weight.(4) The difficulty of synthesizing general standards is further demonstrated by the IRS's failure (after repeated attempts) to promulgate regulations under Section 385 of the Internal Revenue Code,(5) which was enacted by Congress in 1969 and which authorizes the Treasury Department "to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness (or as in part stock and in part indebtedness)."
Even if general standards could be drawn from a single case, however, it is possible to question the extent to which certain of the findings in Laidlaw could or should be considered of general application. For example, the Tax Court might be criticized for
being troubled by the fact that loans were obtained to make capital acquisitions (rather than only to fund operating expenses);(6)
- rejecting the use of fair market value (rather than book value) in computing debt-equity ratios;(7)
- treating agreements to postpone payment as effectively equivalent to subordination;
- considering debt-equity ratios of competitors highly relevant to the debt-equity determination;
- dismissing the existence of a public minority share holding in one of the borrowing US subsidiaries as being irrelevant to the debt-equity determination;
- rejecting as self-serving the US subsidiaries' assertion that their intent was consistent with the form of their instruments; and
- considering as neutral certain factors that may have been helpful to the taxpayers.
It also appears that the Tax Court may have been unduly influenced by the failure of the US subsidiaries to prove that a third party would have lent the same amounts to them on the exact same terms. Indeed, if the acid test of Laidlaw were whether an unrelated third-party lender would have made the loans on the same terms, the debt-equity determination with respect to intercompany loans would be transformed from a fact-specific inquiry into an objective test of exact comparability similar to that used in transfer-pricing cases. In fact, there is authority that the terms of commercial debt should not be stringently compared with the terms of related-party debt in making the debt-equity determination.(8)
We suggest a more practical standard. In particular, a bona fide, third-party offer to finance on the same terms should provide a safe harbor to taxpayers. Unfortunately, a taxpayer that makes an unsuccessful attempt to fall within the purview of such a safe harbor could find itself in the awkward position of building a case for the IRS. Absent the proposed safe harbor, taxpayers should be permitted to rely on their form if they respect it, and courts should weigh the traditional factors recited in the hundreds of decided debt-equity cases (once Laidlaw has been distinguished).
One aspect of Laidlaw that could prove to be enduring and of general application is the effect of inconsistent statements made to different tax authorities. In its briefs in Laidlaw, the IRS latched on to the inconsistency between the statements made by Canadian Parent to Revenue Canada concerning the intercompany loans at issue and the statements made by the US subsidiaries to the IRS concerning the same loans. The IRS argued that such inconsistent statements indicated that the Laidlaw corporate group's "intent was not to create debt, but, instead, to create interest deductions for tax purposes in both the US and Canada."(9) The IRS also used these inconsistent statements to undermine the US subsidiaries' credibility:
[The US subsidiaries'] contentions in this instance are especially egregious, in view of the fact that [Canadian Parent] told Canadian tax authorities that the "debt investments" of [Canadian Parent] (through [Dutch Lender]) in its US affiliates were in the nature of capital investments, and were a part of the subsidiaries' permanent capital, in order to secure favorable tax treatment in Canada. [The US subsidiaries'] inconsistent statements regarding their intentions reveal their willingness to say whatever is to their own tax advantage, and undermine their credibility.(10)
In its findings of fact, the Tax Court dedicated a separate section to a discussion of the audit of Canadian Parent by Revenue Canada. In this section, the Tax Court found as follows:
Canadian income tax authorities audited [Canadian Parent] for 1987 and 1988. [Canadian Parent] wrote that its US subsidiaries used funds that it advanced to them to provide capital and that those funds became part of the permanent capital of the company. [Canadian Parent] said that the advances provided about 35 percent of the total capital of Laidlaw in 1987 and 1988. [Canadian Parent] said that if it were to incur a loss on a loan to a subsidiary it would not be allowed to deduct the loss as a bad debt. [Canadian Parent] said:
3. [Canadian Parent] acts as a conduit in providing funds for its operating subsidiaries. The funds are used by the subsidiaries as working capital and for capital acquisitions. Without these funds, the subsidiaries would be seriously undercapitalized. The loans are in the nature of capital contributions to the subsidiaries.(11)
The Tax Court apparently agreed with the IRS's contention that the US subsidiaries' credibility had been undermined by the inconsistent statements made to US and Canadian tax authorities. In concluding that the manifest intent of the Laidlaw corporate group was to create equity rather than debt, the Tax Court relied in part on the fact that Canadian Parent had "represented to Canadian tax officials that the loans are 'in the nature of capital contributions.'"(12)
For the reasons discussed above, most taxpayers should be able to distinguish their situations from Laidlaw, and the better view seems to be that Laidlaw should not be read to require an objective third-party financing standard in debt-equity cases. Several inferences of general application may, however, be drawn from Laidlaw: (1) taxpayers should respect the form that they choose, (2) taxpayer records can create a road map for the taxing authorities, and (3) taxpayers may be able to use third- party offers of financing as a defense against a debt-equity attack. Taxpayers should also be aware that as cross-border information sharing increases, so will the likelihood that tax authorities will discover any inconsistent positions taken for business and tax purposes or for tax purposes among different jurisdictions.
1. 75 TCM 2598 (1998).
2. There was no issue in this case concerning US withholding taxes.
3. Supra footnote 1, at 2615-16.
4. Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972); Dixie Dairies Corp., 74 TC 476, 493 (1980), acq. 1982-2 CB 1.
5. See TD 7747, 1981-1 CB 141; TD 7801, 1982-1 CB 60; TD 7822, 1982-2 CB 84; TD 7920, 1983-2 CB 69.
6. Compare William T. Plumb, Jr., "The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal" (March 1971) 26 Tax Law Review 369-640, at 520-25.
7. Compare Kraft Foods Co. v. Commissioner, 232 F.2d 118, at 127 (2d Cir. 1956) ("We think it obvious that in the determination of debt-equity ratios, real values rather than artificial par and book values should be applied"); Estate of Miller v. Commissioner, 239 F.2d 729, at 733 and footnote 10 (9th Cir. 1956) (quoting the above language from Kraft Foods, and stating that this "language is in line with other decisions of the Tax Court"); Nye, 50 TC 203, at 216 (1968) (rejecting the use of book values by the IRS in computing the debt-equity ratio of a corporation, and stating that "book values [are] notoriously poor guides to fair market value"), acq. 1969-2 C.B. xxv; and Harkins Bowling, Inc. v. Knox, 164 F. Supp. 801, at 804 (D. Minn. 1958) ("In determining a debt-equity ratio, real and not book value of the capital investment must be used"). See also Plumb, supra footnote 6, at 516: "Attention is not riveted on the book net worth, however, but on the fair market value of the net assets."
8. See, for example, Geftman v. Commissioner, 154 F.3d 61, at 76 footnote 21 (3d Cir. 1998) ("credit may be extended between related parties on terms that differ from those that would exist on the open market"); and Nestle Holdings, Inc. v. Commissioner, 70 TCM 682, at 703 (1995) ("In evaluating the terms of related-party debt, we do not apply a mechanical test of absolute identity between the related-party advances and the debt that actually or hypothetically would have been available . . . but, instead, we seek to determine whether the terms of the advances were a 'patent distortion of what would normally have been avail-able.' . . . We have recognized that 'different creditors invariably undertake different degrees of risk and that, where debtor and creditor are related, the lender might understandably offer more lenient terms than could be secured elsewhere'" (quoting Litton Business Sys., Inc., 61 TC 367, at 379 (1973), acq. 1974-2 CB 3, and G.M. Gooch Lumber Sales Co., 49 TC 649, 659 (1968), respectively)), vacated and remanded on another issue, 152 F.3d 83 (2d Cir. 1998).
9. "Brief for Respondent," supra footnote 1 at 77.
10. "Reply Brief for Respondent," supra footnote 1 at 48 (citations omitted and emphasis added).
11. Supra footnote 1, at 2615-16.
12. Id., at 2620.