Hewlett-Packard Co. v. Commissioner

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
HEWLETT-PACKARD COMPANY AND No. 14-73047
CONSOLIDATED SUBSIDIARIES,
Petitioner-Appellant, Tax Ct. No.
10075-08
v.
COMMISSIONER OF INTERNAL
REVENUE,
Respondent-Appellee.
HEWLETT-PACKARD COMPANY AND No. 14-73048
CONSOLIDATED SUBSIDIARIES,
Petitioner-Appellant, Tax Ct. No.
21976-07
v.
COMMISSIONER OF INTERNAL OPINION
REVENUE,
Respondent-Appellee.
Appeal from a Decision of the
United States Tax Court
Argued and Submitted November 14, 2016
San Francisco, California
2 HEWLETT-PACKARD V. CIR
Filed November 9, 2017
Before: Sidney R. Thomas, Chief Judge, and Alex Kozinski
and Michelle T. Friedland, Circuit Judges.
Opinion by Judge Kozinski
SUMMARY*
Tax
The panel affirmed the Tax Court’s decision on a petition
for redetermination of federal income tax deficiencies that
turned on whether an investment by taxpayer Hewlett-
Packard (HP) could be treated as equity for which HP could
claim foreign tax credits.
HP bought preferred stock in Foppingadreef Investments
(FOP), a Dutch company. FOP bought contingent interest
notes, from which FOP’s preferred stock received dividends
that HP claimed as foreign tax credits. HP claimed millions
in foreign tax credits between 1997 and 2003, then exercised
its option to sell its preferred shares for a capital loss of more
than $16 million. The Tax Court characterized the transaction
as debt, thus upholding the deficiency for the credits.
Acknowledging a circuit split over whether the
debt/equity question is one of law, fact or a mix of the two,
the panel explained that the best way to read circuit precedent
*
This summary constitutes no part of the opinion of the court. It has
been prepared by court staff for the convenience of the reader.
HEWLETT-PACKARD V. CIR 3
is that the test is “primarily directed” at determining whether
the parties subjectively intended to craft an instrument that is
more debt-like or equity-like, taking into account eleven
factors set forth in A.R. Lantz Co. v. United States, 424 F.2d
1330, 1333 (9th Cir. 1970). The panel concluded that the
Tax Court didn’t err in finding that HP’s investment is best
characterized as a debt.
The panel also upheld the Tax Court’s determination that
HP’s purported capital loss, which can be deducted, was
really a fee paid for a tax shelter, which cannot be deducted.
COUNSEL
Alan I. Horowitz (argued), Marc J. Gerson, George A. Hani,
and Steven R. Dixon, Miller & Chevalier Chartered,
Washington, D.C., for Petitioner-Appellant.
Arthur T. Catterall (argued), Francesca Ugolini, and Gilbert
S. Rothenberg, Attorneys; Diana L. Erbsen, Deputy Assistant
Attorney General; Tax Division, United States Department of
Justice, Washington, D.C.; for Respondent-Appellee.
OPINION
KOZINSKI, Circuit Judge:
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
4 HEWLETT-PACKARD V. CIR
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. See generally
Boris I. Bittker & James S. Eustice, Federal Income Taxation
of Corporations and Shareholders ¶ 4.02 (7th ed. 2000).
This case puts us in that awkward position with an
unusual twist. In the textbook example, a taxpaying
corporation wants an investment to be treated as debt so it can
deduct the interest payments. Here, Hewlett-Packard (“HP”)
wants its investment in a foreign entity to be treated as equity,
so that HP will be entitled to the foreign tax credits that the
entity—a so-called “FTC generator”—produces. The United
States taxes the worldwide income of domestic corporations,
but gives them a credit against their domestic taxes for
foreign taxes they (or a subsidiary) pay. FTC generators are
entities that churn out foreign credits for U.S. multinationals,
which companies typically desire if they pay foreign taxes at
a lower average rate than domestic taxes. See Stafford
Smiley & Michael Lloyd, Foreign Tax Credit Generators,
HEWLETT-PACKARD V. CIR 5
39 J. Corp. Tax’n 3, 4–5 (2012). No small sum is on the line:
The transaction here saved HP (and lost Treasury) millions of
dollars.
But HP is entitled to the foreign tax credits only if it
owned at least 10% of the voting stock and received
dividends—in other words, if the investment was really
equity, not debt. I.R.C. § 902(a). So, was it?
FACTS
The tax borscht at issue was cooked up in the 1990s by
AIG Financial Products. The arrangement took advantage of
the fact that contingent interest—interest payments that
depend on future developments, and may never be paid at
all—was immediately taxable in the Netherlands but not in
the United States. This allowed AIG to create a Dutch
company—called Foppingadreef Investments, or
“FOP”—that would (and could) do little else than purchase
contingent interest notes. The entity’s preferred shares would
be owned by an American company, which would receive all
the dividends from the notes, and thus be entitled to claim
foreign tax credits for FOP’s Dutch taxes. ABN, a Dutch
bank, would own FOP’s common shares and sell it the
contingent notes.
Because the accrued contingent interest was taxable in the
Netherlands but not in the United States, FOP would generate
“excess” foreign credits that the American investor could use
to offset American taxes on other foreign profits. And,
because FOP could do little beside purchase contingent
interest notes, the preferred stock guaranteed, in essence, a
fixed stream of payments to the holder of the preferred
6 HEWLETT-PACKARD V. CIR
shares. FOP did not, and indeed could not, have any general
creditors.
In 1996, AIG sold FOP’s preferred stock to HP for a little
over $200 million. HP contemporaneously purchased a put
from ABN, which gave HP the right to sell its shares to ABN
in 2003 or 2007. HP claimed millions in foreign tax credits
between 1997 and 2003. The company then exercised its
option, sold its preferred shares back to ABN, and reported a
sweet capital loss of more than $16 million.
Believing that HP had purchased access to a complex tax
avoidance scheme rather than a bona fide equity interest, the
IRS issued two notices of deficiency, one for a portion of
HP’s foreign tax credits and a second for the capital loss. HP
appealed to the Tax Court, which found that the transaction
was best characterized as debt—thus upholding the
deficiency for the credits—and denied the juicy capital-loss
deduction on the ground that HP failed to meet its burden of
proof.
HP again appeals.
DISCUSSION
A. Debt or Equity?
1. Whether a financial arrangement is best characterized
as debt or equity “is considered by this court to be a question
of fact which, once resolved by a [trial] court, cannot be
overturned unless clearly erroneous.” A.R. Lantz Co. v.
United States, 424 F.2d 1330, 1334 (9th Cir. 1970); see also
Hardman v. United States, 827 F.2d 1409, 1412 (9th Cir.
1987); Bauer v. C.I.R., 748 F.2d 1365, 1366 (9th Cir. 1984).
HEWLETT-PACKARD V. CIR 7
We’re bound by our precedent, but acknowledge a circuit
split over whether the debt/equity question is one of law, fact
or a mix of the two. See Indmar Prods. Co. v. C.I.R.,
444 F.3d 771, 777 (6th Cir. 2006) (question of fact); Cerand
& Co. v. C.I.R., 254 F.3d 258, 261 (D.C. Cir 2001) (mixed
question); In re Lane, 742 F.2d 1311, 1315 (11th Cir. 1984)
(question of law); see also Nathan R. Christensen, Comment,
The Case for Reviewing Debt/Equity Determinations for
Abuse of Discretion, 74 U. Chi. L. Rev. 1309, 1320–26
(2007) (collecting cases and noting that most circuits treat
this question as factual).
We hazard a few observations on this split. First, the
distinction between fact and law is notoriously fuzzy, and can
turn as much on convention as logic. See, e.g., Nathan Isaacs,
The Law and the Facts, 22 Colum. L. Rev. 1 (1922). Second,
calling this a mixed question rather than a factual one doesn’t
add much focus: If it’s a mixed question, we still ask whether
the trial court “based its ruling on an erroneous view of the
law or on a clearly erroneous assessment of the evidence.”
Cooter & Gell v. Hartmarx Corp., 496 U.S. 384, 405 (1990).
But this just means that “[w]hen an appellate court reviews a
district court’s factual findings, the abuse of discretion and
clearly erroneous standards are indistinguishable.” Id. at 401.
Thus, calling this a “mixed question” succeeds only in
pushing the conceptual conundrum back one step: Are we
reviewing a factual finding or not?1
1
For this same reason, we believe the Supreme Court has not
answered the question of which standard applies. The Court has said that
“[t]he general characterization of a transaction for tax purposes is a
question of law subject to review,” while “[t]he particular facts from
which the characterization is to be made are not so subject.” Frank Lyon
Co. v. United States, 435 U.S. 561, 581 n.16 (1978). This framework
8 HEWLETT-PACKARD V. CIR
A better approach is to ask whether the purposes of a
deference regime apply in debt/equity cases. They do.
Corporate tax planning involves abstruse transactions that
generalist appellate courts are ill-equipped to untangle; the
need for “practical human experience” and the “multiplicity
of relevant factual elements” cry out for deference to the Tax
Court.2 C.I.R. v. Duberstein, 363 U.S. 278, 289 (1960);
United States v. McConney, 728 F.2d 1195, 1202–03 (9th Cir.
1984) (en banc). Seen in this light, our “clear error”
framework is not a decisive metaphysical conclusion that debt
is “factual” rather than “legal,” but a practical
acknowledgment that the circumstances warrant great
deference. There are, in short, good reasons why most
circuits apply clear error.
And, like other circuits, we use a multi-factor test to
decide whether an instrument is best characterized as debt or
equity. Our test, incredibly, involves the unguided weighing
of no fewer than eleven non-exclusive factors—whether there
doesn’t tell us whether the debt/equity question is better viewed as part of
the “general characterization” or the “particular facts.”
2
The deferential “clear error” standard applies regardless of whether
a tax case originates in Tax Court or District Court. See Bauer, 748 F.2d
at 1367. This makes sense: In complex tax cases, both Article I and
Article III fact-finders have a proximity to the facts that warrants
deference. Still, the institutional competence of the Tax Court may well
be unique, and we see no authoritative reason why a deference regime
cannot sensibly vary based on unique institutional competences. But we
need not resolve this issue here. Our deference regime is flexible enough
to incorporate such considerations on a case-by-case basis and, in any
event, the number of tax cases that originate elsewhere than the Tax Court
is comparatively meager. See Gerald A. Kafka, Choice Of Forum In
Federal Civil Tax Litigation (Part 1), Prac. Tax Law., Winter 2011, at 55,
60; cf. Franz Kafka, The Trial (Schocken Books 1995) (1925).
HEWLETT-PACKARD V. CIR 9
is a fixed maturity date, whether the investor participates in
management and so on.3
The parties expend considerable effort arguing over
whether “most” of the relevant factors point one way or the
other. But our test isn’t a bean-counting exercise. Instead,
it’s best understood as a non-exhaustive list of circumstances
that are often helpful in guiding a court’s factual
determination. And, while such a free-floating inquiry is
hardly a paragon of judicial predictability, it’s the necessary
evil of a tax code that mistakes a messy spectrum for a simple
binary, and has repeatedly failed to offer the courts statutory
or regulatory guidance. See Howard E. Abrams & Richard L.
Doernberg, Federal Corporate Taxation 75 (5th ed. 2002).
Admittedly, our circuit’s test is somewhat confusing in its
treatment of taxpayer intent. Intent is listed as one of the
eleven factors, but we’ve also said that the test is “primarily
directed” at discovering the intent of the parties to the
transaction. A.R. Lantz Co., 424 F.2d at 1333; see also
Bauer, 748 F.2d at 1367–68. To make matters worse, one of
our important precedents contains a garbled attempt to clarify
the issue: “However, analysis of the factors previously
3
If you must know, the eleven factors are: “(1) the names given to
the certificates evidencing the indebtedness; (2) the presence or absence
of a maturity date; (3) the source of the payments; (4) the right to enforce
the payment of principal and interest; (5) participation and management;
(6) a status equal to or inferior to that of regular corporate creditors;
(7) the intent of the parties; (8) ‘thin’ or adequate capitalization;
(9) identity of interest between creditor and stock holder; (10) payment of
interest only out of ‘dividend’ money; (11) the ability of the corporation
to obtain loans from outside lending institutions.” A.R. Lantz Co.,
424 F.2d at 1333 (citation omitted); see Alex Kozinski & Alexander
Volokh, The Appeal, 103 Mich. L. Rev. 1391 (2005).
10 HEWLETT-PACKARD V. CIR
enumerated, including to subjective resolution of the ultimate
the objective expression of intent, leads issue: Whether the
parties in fact intended the advance to create debt rather than
equity.” A. R. Lantz Co., 424 F.2d at 1333–34.
We think the best way to read our precedent is as follows:
Our test is “primarily directed” at determining whether the
parties subjectively intended to craft an instrument that is
more debt-like or equity-like. A quest for subjective intent
always requires objective evidence, hence the eleven factors.
On this account, all factors on the list could be described as
“evidence of intent.” Direct, objective evidence of
intent—say, an email from an executive stating he wishes to
create an unalloyed debt instrument—is one of the eleven,
and it matters. But assertions of intent don’t resolve our
inquiry, which considers all the “circumstances and
conditions” that speak to subjective intent. Bauer, 748 F.2d
at 1368. Proclaiming an intent to create an instrument that is
“debt” or “equity” doesn’t make it so.
Our precedent’s preoccupation with intent is nonetheless
a little puzzling, since it suggests that a taxpayer could
achieve debt treatment for an instrument that functions as
equity (or vice versa), so long as he had the right state of
mind in crafting the instrument. Were we writing on a barren
slate, we might say that our test is simply directed at
determining whether an instrument functions more like debt
or equity. There’s nothing magical about intent.
Nonetheless, we believe our circuit’s roundabout intent-based
test merges with this simple function test in all but a few
outlandish cases. Cf. United States v. Powell, 955 F.2d 1206,
1212 (9th Cir. 1991) (“[A] jury is not precluded from
considering the reasonableness of the interpretation of the law
in weighing the credibility of the claim that the [defendants]
HEWLETT-PACKARD V. CIR 11
subjectively believed that the law did not require that they file
income tax returns.”); Cheek v. United States, 498 U.S. 192,
203–04 (1991) (“[T]he more unreasonable the asserted beliefs
or misunderstandings are, the more likely the jury will
consider them to be nothing more than simple disagreement
with known legal duties imposed by the tax laws.”).
Crucially, both tests allow us to resist taxpayer
gamesmanship: The clever taxpayer who designs a debt
instrument but proclaims an unpersuasive intention to own
equity would fail via either path.
With this background in place, we have no difficulty
concluding that the Tax Court didn’t err in finding that HP’s
investment in FOP is best characterized as debt. While the
factors point in different directions, the Tax Court committed
no clear error in considering or weighing them. It
appropriately found that the formal labels attached to the
documents didn’t settle the inquiry. Instead, of particular
importance to the Tax Court was the de facto presence of a
fixed maturity date, and HP’s de facto creditor’s rights. The
Tax Court concluded that the deal had a de facto maturity
date because HP had an overwhelming economic incentive to
divest itself of FOP after 2003: After that year, FOP would
have negative earnings, thereby preventing HP from claiming
foreign tax credits. HP knew this, and never expected to stay
in the transaction after 2003. HP’s income was also highly
predictable: It was entitled to semiannual payments equal to
97% of the after-tax base interest on the notes, and had a
contractual remedy against ABN and, if ABN failed to pay
interest on the notes, FOP as well. While payment of the
dividends was contingent on FOP’s earnings, the transaction
was arranged such that FOP’s earnings were all but
predetermined. In short, HP’s investment earned it a limited
12 HEWLETT-PACKARD V. CIR
return for a fixed period, and the Tax Court made no error in
concluding that the investment was debt.
2. Nor did the Tax Court err in considering HP’s put,
purchased from ABN, as part of the “overall transaction” in
characterizing HP’s interest in FOP as debt or equity. See
Hardman, 827 F.2d at 1411. FOP was a party to the
shareholders’ agreement, and was obligated to take all
“necessary or appropriate” actions to implement the put. In
fact, FOP couldn’t have done anything to undermine the
exercise of the put, because FOP was precluded from issuing
additional stock or carrying out any business other than
buying contingent interest notes. The Tax Court thus
reasonably considered it as part of an integrated transaction.
We’ve similarly integrated transactions in previous
debt/equity cases. See, e.g., C.I.R. v. Palmer, Stacy-Merrill,
Inc., 111 F.2d 809 (9th Cir. 1940).
B. The Capital Loss
The tax code and regulations allow for the deduction of
bona fide losses, I.R.C. § 165(a), but fees paid for a tax
shelter cannot be deducted, see, e.g., Wells Fargo & Co. v.
United States, 641 F.3d 1319, 1330 (Fed. Cir. 2011). If the
IRS denies a deduction, the taxpayer bears the burden of
proving by a preponderance of the evidence that the IRS
determination was incorrect. Welch v. Helvering, 290 U.S.
111, 115 (1933). If the Tax Court concludes that the taxpayer
has not met that burden, we must uphold that judgment if it
is based on a permissible view of the evidence. See, e.g.,
MacDonald v. Kahikolu, Ltd., 581 F.3d 970, 976 (9th Cir.
2009).
HEWLETT-PACKARD V. CIR 13
The Tax Court’s judgment—that HP’s purported loss was
really a fee paid for a tax shelter—was certainly based on a
permissible view of the evidence. Indeed, internal HP
communications referred explicitly to the “fee” that HP
needed to pay AIG in order to participate in the FOP deal. A
clawback agreement even obligated AIG to compensate HP
if HP didn’t get its desired tax results.
HP almost got its desired tax results.
AFFIRMED.