In Uncategorized on 06/19/2012 at 18:22

Or, How to Make It Look Like Debt

That was the task of the advisors and consultants when ScottishPower, supplier of megawatts to Scotland, England and Wales, went shopping for a US public utility and bought PacifiCorp, supplier of “electricity and energy-related services to retail customers in several States, including Oregon, Utah, Washington, Idaho, Wyoming and California.” 2012 T.C. Mem. 172, at p. 3.

Part of the deal involved floating-rate and fixed rate instruments, which the Scots wanted to be debt (so that their American subsidiary could deduct interest) and which IRS wanted to be equity (so they couldn’t), in NA General Partnership & Subsidiaries, Iberdrola Renewables Holdings, Inc. & Subsidiaries (Successor in Interest to NA General Partnership & Subsidiaries), 2012 T. C. Mem. 172, filed 6/19/12, with Judge Kroupa, untangler of corporate cats’-cradles, at the switch.

The Scots saw PacfiCorp floundering, its stock depressed and its management seeking a suitor. The Scots, ever alert to a canny manoeuvre and knowing PacifiCorp had a solid core business, set up an acquisition partnership, swapped stock to acquire PacifiCorp, and unloaded some of PacifiCorp’s Australian holdings, which were diverting attention from the core business.

The acquisition entity funded the acquisition of ScottishPower stock to swap for PacifiCorp stock in the merger with floating-rate and fixed rate paper.

The Scots did it right: fixed maturity dates, fixed due dates for interest, stated rate of interest, default and acceleration of principal provisions, prepayment and call provisions.

Of course, the subsidiary missed a couple of due dates for interest while some regulatory issues were being addressed, and a couple of payments were made by way of journal entries without cash changing hands.

Applying Ninth Circuit learning, Judge Kroupa knocks out IRS’ $188 million deficiency.

“The Court of Appeals for the Ninth Circuit considers eleven factors to determine whether an advance is debt or equity. These factors include (1) the name given to the documents evidencing the indebtedness; (2) the presence of a fixed maturity date; (3) the source of the payments; (4) the right to enforce payments of principal and interest; (5) participation in 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 stockholder; (10) payment of interest only out of ‘dividend’ money and (11) the corporation’s ability to obtain loans from outside lending institutions. No one factor is decisive, and the weight given to each factor depends on the facts and circumstances.  Our objective is not to count the factors, but rather to evaluate them.” 2012 T.C. Mem. 172, at pp. 16-17 (Citations omitted).

Let’s look at the easy ones; 1, 2 and  4 go for the Scots; 9 goes for the IRS.

Number 7 might have been a cliffhanger, because of the tax benefit if the notes are debt, but Judge Kroupa says that’s all right: “Indeed, tax considerations permeate the decision to capitalize a business enterprise with debt or equity. Interest paid on indebtedness is deductible while no deduction is allowed for dividends paid. Moreover, ScottishPower’s desire to obtain interest expense deductions in capitalizing NAGP [the acquisition sub] with debt does not show that the parties lacked the requisite intent to enter into a debtor-creditor relationship, as respondent [IRS] implies. If anything, it shows the opposite.” 2012 T.C. Mem. 172, at pp. 25-26.

Number 5 goes for the Scots; they can’t increase their management participation over the acquisition sub, because they already own and control 100% of its voting power. Not even Max Bialystok can beat that.

As for Number 6, IRS says the notes don’t prohibit subordinate or senior financing, and the acquisition sub did get a credit line from Royal Bank of Scotland, to which ScottishPower was subordinate, although that was paid back. Doesn’t matter, says Judge Kroupa: “We are not persuaded by respondent’s argument. We have recognized that certain creditor protections are not as important in the related-party context. For example, we have previously found that a parent’s 100% ownership interest in its subsidiary adequately substituted for a security interest, or at least minimized its importance. Similarly, ScottishPower as NAGP’s sole shareholder had the power to prevent NAGP from taking on any additional debt, including senior debt.” 2012 T. C. Mem. 172, at p. 23 (Citation omitted). Number 6 goes for the Scots.

On Number 3, source of cash to pay debt, the Scots call on expert Israel Shaked, who says the projected cash flow from PacifiCorp’s operations plus the Australian sales proceeds would be sufficient to pay off the notes at maturity. IRS goes with Robert Mudge, who says there wouldn’t be enough cash, because Robbie assumes the Australian cash will be a dividend, so he’s out of the money, and Israel Shaked brings home the bacon for the Scots. There’s also a minor regulatory glitch from Oregon PUC about paying out too much cash, but Judge Kroupa says that’s de minimis as it only applies to Oregon, and the rest of the territory has no such restriction.

Number 8 finds Mr. Mudge short of amperage once more, while Israel Shaked again lights the lamp. While maybe the acquisition sub wouldn’t have an S&P “A” rating, it still would get a “B”, and that’s not too shabby; at least, not so shabby as to make repayment remote.

Bottom line: Scots win it.

Takeaway: Good planning and good expert testimony carry the day.

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