A Bright Line for Hybrid Tax Breaks?

The IRS weighs in on when such securities may be considered equity rather than debt.
Robert WillensJune 20, 2011

Although issuing hybrid securities offers companies a chance to meet the needs of sophisticated shareholders, they sometimes get so complex that whether to define them as debt or equity becomes a thorny matter. The complexity also makes hybrids hard to peg as debt or equity for tax purposes.

That’s important, because in some cases issuing a security as stock rather than debt provides a tax advantage to the issuers. In a recent Internal Revenue Service letter ruling (LTR 201120003) on May 20, the IRS appears to have taken a whack at providing some guidance on when a hybrid can be considered equity for federal tax purposes.

The case before the IRS involved a mutual fund, which we’ll call Issuer, that lists its common stock on the New York Stock Exchange. Issuer’s assets consist mainly of debt instruments generating interest exempt from federal and state income.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

Issuer wanted to put forth a security that would resemble auction-rate preferred stock, except that the security would have features intended to make it eligible to be issued as a money-market-fund investment. (Offered under Dutch auctions, auction-rate preferred shares include dividend rates that are reset after fixed periods.)

Further, Issuer would offer investors a “liquidity facility” that would be provided by a bank or other financial institution as backing for the security. Shareholders would be entitled to tender their shares for remarketing periodically or in the event of a failed remarketing for purchase by the bank. Each share would have a dividend rate that would normally be reset every seven days (“the rate period”). Issuer would be able to pay dividends on the security only if the dividends were properly declared by the board and paid out of legally available funds.

An unaffiliated remarketing agent would be responsible for setting the dividend rate for each rate period. The dividend rate for any rate period would be the lowest rate that results in the security having a market value equal to the purchase price on the first day of the rate period. But the dividend rate would never exceed the maximum dividend rate calculated for each rate period.

Issuer would be able to redeem shares of the security at any time. Shareholders would have the option to tender shares for remarketing at the purchase price on a specific purchase date. Further, the security would be subject to mandatory tender for remarketing at the purchase price upon the occurrence of certain events. A remarketing failure would occur if any of the shares tendered for remarketing remained unsold on the purchase date, in which case the shares would be delivered to the bank for purchase under the liquidity facility.

Even if the bank bought shares under the liquidity facility, efforts to remarket the security would continue. If the bank held any share acquired under the liquidity facility for a continuous period of at least six months, Issuer would be required to redeem that share from the bank at a price equal to the purchase price.

Issuer asked the IRS for a ruling that the security would be treated as equity and not indebtedness for tax purposes — and got what it wanted.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for