* 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 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.