Section of Taxation Publications
  VOL. 60
NO. 3

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Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.

Equity, Debt, NOT—The Tax Treatment of Non-Debt Open Transactions
Michael S. Farber*

* Partner, Davis Polk & Wardwell.


Much has been written, and yet relatively little is known, regarding the distinction between debt and equity for U.S. federal income tax purposes. This Article takes that body of law and lore as a point of departure for the exploration of a third axis in the characterization of securities: what this Article will call non-debt open transactions or NOTs. This Article will explore a variety of instruments with features creating varying degrees of uncertainty as to tax treatment in order to attempt to establish some principles from which to distinguish a NOT from a debt instrument or other security, and then will discuss the possible tax treatment of such instruments, both under current law and as a normative matter.

A NOT for purposes of this Article means a “fully paid” instrument that is neither debt nor equity for U.S. tax purposes. A paradigm example of a NOT is a prepaid equity forward contract, like that described in Revenue Ruling 2003-7—although, as will be discussed, the ruling does not analyze whether the instrument described therein is or is not a NOT. The defining features of NOTs, as a class, are that (1) they have subordination features, terms to maturity, or other features that preclude (in the author’s view at least) characterization as equity of their issuer but (2) they lack most of the classic features of debt. For example, many of the instruments discussed here lack an unconditional right from the holder’s perspective by the terms of the instrument to receive back the instrument’s invested amount—at least, not all of it—or to receive any amount of noncontingent stated or discounted interest. Much of the ambiguity surrounding NOTs involves the question of whether the instrument is or might be characterized as debt for U.S. tax purposes.

Once one has figured out how to determine whether an instrument is a NOT, which is essentially a process of figuring out how the instrument is not taxed—that is, as simple debt or equity, the next task is to determine how the instrument is taxed. As a starting point, it is worth observing that the concept of an “open transaction” is somewhat amorphous. There are many types of instruments that could be thought of as open transactions—indeed, as a literal matter, any instrument that is not subject to at least annual mark-to-market taxation is an open transaction, in the sense that at least some economic gains or losses are not, or may not be, accounted for currently. Debt itself has this feature. There is a second, very real, sense in which indebtedness, for example, is an open transaction—the borrower does not include the proceeds of its borrowing as income upon receipt, nor does it account for the changes in the economic value of its obligation to return those proceeds at maturity, due largely to inflation and changes in interest, or more properly, discount rates. Instead, the borrower accounts for the difference between the amount of those proceeds and the amount paid to retire the debt generally as redemption premium or cancellation of debt income. (Thus, the NOT acronym, whatever else it is, is not redundant). However, debt is not an open transaction in the sense that interim payments or accruals on debt are deductible and includible currently by the issuer and holder(s), respectively. In this sense, debt resembles short sales, in which the proceeds are not accounted for until maturity but interim payments—income equivalents and borrowing fees—are generally accounted for currently. An example of a pure open transaction would be an option, in which the premium is not accounted for currently by either party and there are no interim inclusions or deductions. Viewed this way, ownership of non-income bearing assets such as commodities and non-dividend-paying stock could also be characterized as a pure open transaction.

Thus, concluding that a NOT is an open transaction is not the same as determining how it is accounted for. NOTs could be subject to several different tax regimes, including pure open transaction accounting like options and non-dividend-paying stock, interim accounting on the basis of some form of imputation like discount or contingent payment debt, and bifurcation into components that fit neatly into the categories of existing law (which as a broad conceptual approach will be referred to as “component analysis”). Another possibility, which in fact produces results similar to a component analysis, is to treat the NOT as a prepaid notional-principal contract. This treatment seems plausible, (indeed, as will be discussed, might even be proper under current law) for instruments that provide for interim periodic payments, but does not technically appear to be appropriate for noncoupon bearing NOTs.

This Article will take as a premise the observation that it is desirable to tax holders and issuers of the instruments described in this Article symmetrically, in the first instance. This is in many contexts not a comfortable premise, and as will be seen, is often not a premise that has guided Congress or Treasury. Moreover, many of the instruments described in this Article are commonly issued by entities that are, or are affiliated with, dealers in securities subject to the mark-to-market regime of section 475, potentially resulting in an inherent asymmetry in treatment. However, dealers in securities may not mark-to-market their own issued debt, so the overall question of whether any of the instruments described herein constitutes indebtedness is one that is generally relevant to both issuers and holders.

The question of whether symmetry is a virtue or a vice generally is a debatable one, and even where it is agreed that symmetry is virtue, other policy concerns can and do override. A fair bit of harm to the tax system has been caused by asymmetries. In any event, this Article is focused on the characterization of certain instruments, both under current law and as a normative matter. The asymmetries that exist in the tax system typically result from the status or the particular circumstances of the parties to a transaction for tax purposes ( e.g., dealers, traders, hedgers, tax exempts, non-U.S. persons). There are some instances of asymmetries applicable to the treatment of a particular instrument; for example, section 163( l) treats issuers and holders inconsistently, although this asymmetry does turn on the status of the issuer, or one of its affiliates, as a holder of the underlying assets. And, of course, the disparate treatment of dividends on stock in the hands of issuers and investors is what has created our two-level tax system.

A regime that characterizes an instrument differently from the issuer’s and the investor’s perspective, without any regard to their particular tax status or circumstances, must reflect bad tax policy because it must reflect a failure to determine an appropriate accounting method for the instrument itself. Once it is determined how the instruments described in this paper should be taxed in themselves, it may then make sense to consider creating status based asymmetries (although again, those may ultimately cause more harm than good); that question, however, is beyond the scope of this Article.

Part I of this Article describes various instruments being issued in the capital markets today, including prepaid forwards, reverse and mandatory exchangeables, and credit linked notes. Part II briefly surveys the law relating to the traditional debt-equity dichotomy and also reviews some of the authorities touching, to varying degrees, on the characterization and taxation of NOTs. Part III discusses the appropriate treatment of our putative NOTs, both under current law and as a normative matter. Part IV offers several conclusions.


Published by
Section of Taxation, American Bar Association
With the Assistance of
Georgetown University Law Center


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