(This post will be updated from time to time, as needed. Many of my readers are likely to have more and better insight into specific debt versus equity matters regarding bonds. If you have any comments, please leave a comment using the “reply” feature below.)
Whether an obligation is considered debt for federal income tax purposes depends on the terms of the obligation instrument and all surrounding facts and circumstances. In Notice 94-47, the Internal Revenue Service describes several factors listed below that may be considered in making this determination. No particular factor is conclusive in making a determination of whether the obligation constitutes debt or equity, and the weight given to any factor depends on the facts and circumstances and the overall effect of an instrument’s debt and equity features.
- Whether there is an unconditional promise on the part of the issuer to pay a sum certain on demand or at a fixed maturity date that is in the reasonably foreseeable future (“yes” indicates debt);
- Whether holders of the instruments possess the right to enforce the payment of principal and interest (“yes” indicates debt);
- Whether the rights of the holders of the instruments are subordinate to the rights of general creditors (“no” indicates debt);
- Whether the instruments give the holders the right to participate in the management of the issuer (“no” indicates debt);
- Whether the issuer is thinly capitalized (“no” indicates debt);
- Whether there is identity between holders of the obligations and stockholders of the issuer (“no” indicates debt);
- The labels placed upon the instruments by the parties;
- Whether the instruments are intended to be treated as debt or equity for non-tax purposes, including regulatory, rating agency or financial accounting purposes.
Notice 94-47 was issued in part to address transactions being completed in which the obligations were structured to look like debt for federal income tax purposes but as equity for regulatory, rating agency or financial accounting purposes (see factor 8 above). Rev. Rul. 85-119, 1985-2 C.B. 60 was used as authority or guidance in treating such obligations as debt. The IRS cautions that the ruling should be analyzed narrowly and indicates that it does not feel bound by any arrangements that do not mirror the facts in the ruling.
See also L. Howard Adams, “What Role for Equity in Applying Factors for Distinguishing Debt?,” Tax Notes, March 4, 2013, for a good discussion of factors relevant to determining the debt/equity status of obligations.