On August 7, 2009, the IRS released Chief Counsel Memorandum 200932049 (the “Memorandum”), addressing the treatment of “trust preferred securities.” Trust preferred securities, treated as debt for tax purposes, are hybrid instruments that have features typically associated with debt instruments as well as some features that arguably are equity flavored.
In a typical structure, a trust, set up by an issuer that wishes to access the capital markets, issues “preferred securities” to investors and uses the proceeds to purchase unsecured, junior subordinated debt obligations (“notes”) issued by the issuer. The trust is structured as a grantor trust – a complete pass-through entity, not subject to an entity-level tax – and investors are treated as owning their pro rata share of the trust’s assets (i.e., the notes). In a plain vanilla, traditional structure (to be contrasted with the “enhanced” variation discussed below), under the terms of the notes, the issuer may elect to defer payments of interest for a specified number of years (typically five years), and the notes typically have a term of 30 – 49 years. For federal income tax purposes, the issuer receives an interest deduction on the interest it pays on the notes.
“Enhanced” trust preferred securities are a form of trust preferred securities. These instruments have additional features not found in the basic trust preferred structure. For example, interest may be deferred for periods in excess of five years, deferred interest may be subject to “caps” in bankruptcy (i.e., the investor could lose its claim on a portion of deferred interest payments in excess of a specified cap in bankruptcy), and the notes may have a term in excess of 49 years.
The enhanced features can result in significant benefits from ratings agencies, which give more or less “equity credit” depending on which of the features are included in any particular security. The primary competing consideration is the federal income tax treatment of the notes. If pushed too far, tax practitioners worry that the notes may lose their debt treatment, resulting in a denial of interest deductions for the issuer.
The facts of the Memorandum, while redacted, address enhanced trust preferred securities. The terms of the notes described include optional deferral of interest, mandatory deferral of interest during any period when the issuer is not in compliance with specified financial tests, caps on recovery of deferred interest in bankruptcy, and a term, one may reasonably hazard, significantly in excess of 49 years.
In determining whether the notes constitute debt or equity for federal income tax purposes, the Memorandum recommended that the issuer’s characterization of the notes as debt should not be challenged. In arriving at this conclusion, the Memorandum placed a great deal of emphasis on the economic reality in which the notes were issued. In particular, it emphasized the issuer’s status as a long-standing and financially sound company, the remote likelihood that the issuer would voluntarily suspend payments of interest or that it would be forced to do so, and the fact that the interest rate borne by the notes suggested that the market did not consider the long maturity of the instruments to be a significant risk.
Enhanced trust preferred securities have been in the market for nearly four years. The Memorandum, which is internal government guidance that cannot be relied on, generally confirms the consensus among practitioners that, for the right issuer in the right economic context, the enhanced features described above should not push an instrument so far along the debt-equity continuum that it loses its debt characterization.