* U.S. Tax Court case weighs debt versus equity
* Ruling on interest deductions expected soon
* Last big debt-equity tax case decided in 1998
By Kim Dixon
WASHINGTON, June 6 (Reuters) - The U.S. Tax Court is expected to issue shortly its first major decision in years on the tax deductibility of interest in certain corporate debt transactions in a case that pits the UK's Scottish Power against the Internal Revenue Service.
The IRS is challenging $932 million in interest deductions taken by the power utility on $4 billion in intercompany notes issued between company units. The tax collector argues that the transactions should be treated as equity, which would nullify the deductions taken by the Spanish-owned company.
Under corporate tax law, interest paid on debt is tax deductible, a feature of the U.S. tax code that is often abused and that critics say unwisely favors debt over equity. In this case, Scottish Power's deductions cut its taxable U.S. income.
Scottish Power is one of Britain's "Big Six" energy suppliers, and is a unit of Iberdrola Renewables, owned by Spain's Iberdrola SA, one of the world's largest utilities.
An Iberdrola spokeswoman said the company does not comment on pending litigation.
The Scottish Power case involves its 1999 purchase of U.S. utility PacifiCorp. A separate U.S. corporate unit became the parent company, which then issued fixed notes to Scottish Power.
The IRS has been scrutinizing corporate debt issuance to foreign units for years, at times arguing deals are structured to skirt billions of dollars in tax. The Scottish Power ruling would be the Tax Court's first major decision in this area since the late 1990s.
Multinational companies say they have the right to structure subsidiaries as they like, with debt or equity, regardless of the business purpose or accompanying tax benefits.
"My sense is this is pretty common," said University of Michigan Tax Law Professor Reuven Avi-Yonah, referring to the structures used by Scottish Power.
"It involves cross-border restructuring. In M&A (mergers and acquisitions) you frequently put on additional debt - but from a related party you are free to tailor the terms, so it will be as equity-like as possible, but qualify as interest for tax purposes," he said.
Courts have used various tests to determine if a corporate structure should be treated as debt or equity, weighing factors such as interest rates and the likelihood a debt will be repaid.
One of the last major cases involving the corporate treatment of debt versus equity came in 1998, when the Tax Court disallowed $133 million in interest expenses claimed by Canadian transportation company Laidlaw, forcing it to reclassify the amount as equity.
Laidlaw is now a part of the UK's FirstGroup PLC.
A 1995 decision involved Nestle Holdings, where the Tax Court also ruled against the food manufacturer. An appeals court later reversed part of that decision.
"There is not a lot of precedent that supports the government's position, and I think they are trying to create new precedent here," said Pam Olson, a former assistant secretary for tax policy at the U.S. Treasury under former President George W. Bush. She is now at PricewaterhouseCoopers.
Foreign companies, particularly in the UK, have developed highly structured ways of developing interest deductions in the United States to trim their U.S. tax bills without generating taxable income in the UK, tax lawyers said.
Though interest expenses on debt are deductible in the United States, dividend payments on shares of stock are not.
Economists say the disparity skews economic decisions, encouraging companies to take on debt rather than issue stock.
President Barack Obama and some Republicans have called for redressing this "debt bias" by making the tax treatment of debt and equity more neutral. Any big changes would likely have to wait until lawmakers tackle a broad scrubbing of the U.S. tax code, possible in the next few years, but by no means certain.
Accounting firm Ernst & Young proposed the structure in the Scottish Power case, according to court filings.