Security call: Determining whether debt is a security (2024)

Editor: Greg A. Fairbanks, J.D., LL.M.

Whether a corporation's debt is a security could have significant tax ramifications when the debt is exchanged for stock or new debt. Specifically, Sec. 354 provides that no gain or loss is recognized to a security holder who surrenders securities in exchange for stock or securities under certain circ*mstances (Regs. Sec. 1.354-1(a)). Similarly, Sec. 355 provides that no gain or loss is recognized by a security holder on the receipt of securities if certain requirements are met. Sec. 356 applies the rules when Secs. 354 or 355 would otherwise apply but other property is received.

Despite its significance, the term "security" is not comprehensively defined in the Code or regulations for the purposes of Subchapter C. For the purpose of reorganizations, Regs. Sec. 1.368-1(b) states that "a short-term purchase money note is not a security of a party to a reorganization" (cf. Secs.165(g)(2) and 475(c)(2)).

Courts have decided whether a debt is a security in many cases. The IRS has also provided guidance. The primary factor often cited is the length of the maturity term. As noted in a reputable treatise, "Courts have ordinarily focused on the instrument's maturity date: A term of five years or less seems to be too short to qualify a note as a security, while a term of ten years or more is apparently sufficient to bring a note within the statute" (Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, ¶12.11[3] (7th ed. 2015)). However, courts and the IRS have based their analysis on more factors than merely the length of a debt's term. This item provides a recap of some notable authorities, with observations and commentary.

Security cases

The Supreme Court held in Helvering v. Watts, 296 U.S. 387 (1935), that bonds payable in annual installments over seven years were securities. Without deep analysis, the Court stated, "The bonds, we think, were securities within the definition, and cannot be regarded as cash" (id. at 389).

The Seventh Circuit in Burnham, 86 F.2d 776 (7th Cir. 1936), held that notes with a 10-year term were securities. In Burnham, a corporation issued stock in exchange for the 10-year notes, and the noteholder was the principal creditor of the corporation. The court stated, "We think it can not be said that long-term, promissory notes are not of sufficient dignity and formality to be called securities" (id. at 777).

In Neustadt's Trust, 131 F.2d 528 (2d Cir. 1942), the Second Circuit held that an exchange of new debentures for existing debentures was an exchange of securities that qualified as a recapitalization. The taxpayer held corporate debentures that matured in 20 years and provided for interest at 6% payable semiannually. The issuer exchanged them for new debentures that matured in 10 years and paid 3.25% interest semiannually. The new debentures were also convertible into common stock at the option of the holder. In determining that the exchange was a recapitalization, the court stated, "By changing the interest rate and date of maturity of its old bonds and adding a conversion option to the holders of the new, the corporation could strengthen its financial condition, while the bondholders would not substantially change their original investments by making the exchange" (id. at 530).

The Tax Court in Camp Wolters Enterprises, Inc., 22 T.C. 737 (1954), aff'd, 230 F.2d 555 (1956), specified a test for determining whether an instrument was a security that was based on more factors than the length of the debt's term. In Camp Wolters, a corporation issued nonnegotiable unsecured promissory notes in exchange for property. The notes accrued interest and became due in five annual installments between the fifth and ninth years. The notes were subordinate to another debt of the corporation, and no payment could be made on the notes until the senior debt was fully repaid. The court concluded that the notes were securities because the holders assumed a substantial risk of the corporation's enterprise. Notably, the notes were actually redeemed within two years, but the court examined whether the notes were securities as of the date of issuance without hindsight. The court stated:

The test as to whether notes are securities is not a mechanical determination of the time period of the note. Though time is an important factor, the controlling consideration is an over-all evaluation of the nature of the debt, degree of participation and continuing interest in the business, the extent of proprietary interest compared with the similarity of the note to cash payment, the purpose of the advances, etc. [emphasis added; 22 T.C. at 751]

The Tax Court in D'Angelo Associates, Inc., 70 T.C. 121 (1978), held that even a demand note could be a security under certain circ*mstances. In D'Angelo, an individual transferred his rental property to a corporation (Associates) in exchange for cash, the assumption of a liability related to the property, and a demand note. On the date of issuance, (1) there was no foreseeable payment on the demand note; (2) Associates did not have sufficient liquid assets to retire the demand note; (3) the repayment of the demand note could only occur through the sale of the property; and (4) the repayment was intended to be derived from the rental earnings of the property and would take many years. The demand note was also subordinate and would not be satisfied until the satisfaction of the senior obligation that encumbered the property.

The Tax Court in D'Angelo held that the demand note was a security. The court acknowledged that a short-term note is generally not a security, but a short-term note is a security when the stated maturity is unrealistic or ignored by the parties. The court also thought that the purpose of the demand note indicated that it was a security because the transfer of the property constituted a permanent contribution of assets and not a short-term advance.

The Fifth Circuit reached a similar conclusion in Mills, 399 F.2d 944 (5th Cir. 1968), by holding that a one-year note was a security when it would not be repaid after one year and would be indefinitely extended when it became due.

Nonsecurity cases

The decision in Pinellas Ice & Cold Storage Co., 287 U.S. 462 (1933), established when debt is clearly not a security. In Pinellas, a corporation transferred substantially all of its assets to another corporation for cash and three promissory notes that matured in 45, 75, and 105 days, respectively. The promissory notes were secured by collateral. The Supreme Court held that the promissory notes did not constitute securities for purposes of the reorganization provisions because they were an equivalent of cash. The Court stated:

It would require clear language to lead us to conclude that Congress intended to grant exemption to one who sells property and for the purchase price accepts well secured, short-term notes (all payable within four months), when another who makes a like sale and receives cash certainly would be taxed. [id. at 469]

The Court also noted what was lacking in Pinellas when it stated, "Certainly, we think that to be within the exemption the seller must acquire an interest in the affairs of the purchasing company more definite than that incident to ownership of its short-term purchase-money notes" (id. at 470).

On similar grounds, the Second Circuit held that six-month notes and demand notes were not securities in Sisto Financial Corp., 139 F.2d 253 (2d Cir. 1943). In Sisto, the court stated, "The secured notes payable in six months or less were but short term obligations having the character of temporary evidence of debt, as it fluctuates in financing for current expenses, as distinguished from the well known permanent, or semi-permanent, status of long term obligations, which are to be treated as securities. ... A fortiori, the demand notes were not securities" (at 255–256).

Notwithstanding a longer term, the Tax Court in Brown, 27 T.C. 27 (1956), held that an installment contract payable in annual payments over 10 years was not a security. In Brown, a partnership transferred property to a corporation owned by its partners in exchange for the installment contract. Title to the property was reserved for the sellers, and the corporation was required to insure the property. The corporation was capitalized with a debt-to-equity ratio of 2 to 1 including the installment contract and was profitable in the near term. After citing Camp Wolters, the court reasoned that the installment contract was not intended to ensure a continued participation in the business. The court stated, "Although in certain particulars the contract may resemble a bond, essentially it partakes of the nature of a contract of sale, and in our view does not constitute a security" (id. at 36).

Even with a troubled debtor, the Third Circuit in Neville co*ke & Chemical Co., 148 F.2d 599 (3d Cir. 1945), held that certain notes were not securities. In Neville co*ke, a corporation (Davison) owed debt to two creditors (Hillman and Rainey) that also owned stock in Davison. In 1933, Hillman and Rainey transferred their debt and stock to a newly formed corporation, Neville co*ke. The debt owed by Davison to Neville co*ke consisted of accounts receivables, mortgage bonds, and $1,129,000 of notes. The notes consisted of (1) $629,000 due in three years; (2) $250,000 due in four years; and (3) $250,000 due in five years. In 1935, Davison filed for bankruptcy, and a plan of reorganization was approved by a court in 1936. Under the plan, Neville co*ke received new debentures with the same principal amount and stock in exchange for the notes. The new debentures had a fair market value (FMV) equal to their face amount, according to the Tax Court (see Neville co*ke & Chemical Co., 3 T.C. 113, 119 (1944)).

The Third Circuit concluded that the notes were not securities. First, the court noted that Hillman had received $1 million of the notes ($500,000 due in three years, $250,000 due in four years, and $250,000 due in five years) in 1932 in an exchange for preexisting short-term notes of $1 million, some of which were past due. Hillman had made original cash advances in 1930 under the condition that Davison gave business to Hillman, so the court thought there was no intention of investing in Davison's business. Second, the court concluded that certain rights that were afforded to Hillman and Rainey under an agreement entered into in 1932 did not matter. Specifically, the 1932 agreement required Davison and its shareholders to agree that certain creditors became members of its board of directors, including representatives of Hillman and Rainey. However, Neville co*ke was not a party to the 1932 agreement, and the board rights did not succeed to Neville co*ke from possession of the notes. Thus, the court did not attribute such rights to Neville co*ke, even though it was set up by Hillman and Rainey for the reorganization.

In addition, the taxpayer argued that the notes were securities because the 1932 agreement gave Neville co*ke an option to convert up to 50% of the notes into preferred stock of Davison. However, the court concluded Neville co*ke was a creditor, and the fact that it had an option to become a shareholder did not change whether Neville co*ke was a security holder, unless and until it exercised the option.

IRS guidance

The IRS has provided guidance on when a debt instrument is a security. In Rev. Rul. 59-98, a corporation issued bonds in 1946. The bonds were payable between three years and 10 years, and the average time to maturity was 6½ years. All of the bonds were purchased by individuals as investments. In 1957, after several years of serious financial difficulties, the corporation gave new common stock to the bondholders in exchange for the bonds. Prior to the exchange, none of the bondholders were shareholders. After the exchange, the bondholders owned 40% of the common stock. The FMV of the stock issued for each bond was substantially less than the principal amount. The IRS ruled that the bonds were securities because they: (1) were secured by a mortgage on the corporation's property; (2) had an average life equal to 6½ years; and (3) were purchased for investment purposes by persons other than stockholders.

The IRS also ruled in Rev. Rul. 2004-78 that debt instruments issued by an acquiring corporation (Acquiring) in a reorganization under Sec. 368 were securities when they were issued for securities of a target corporation (Target). In Rev. Rul. 2004-78, Target had issued debt instruments that had an original term of 12 years, which were securities. Two years prior to their maturity, Target merged with and into Acquiring in a reorganization defined in Sec. 368(a)(1)(A). As a result of the merger, the holders exchanged their Target debt for new debt issued by Acquiring with identical terms to the Target debt, including the maturity date, except that the interest rate changed to reflect the difference of creditworthiness between Target and Acquiring. The modification of the interest rate was a significant modification under Regs. Sec. 1.1001-3. Thus, the Acquiring debt was treated as a new debt issued by Acquiring with a maturity term of two years on the date of the merger.

In Rev. Rul. 2004-78, the IRS noted that an instrument with a term of two years would generally not qualify as a security, stating, "Under case law, an instrument with a term of less than five years generally is not a security." However, notwithstanding that the Acquiring debt had a term of two years, the IRS concluded that the Acquiring debt was a security because it represented a "continuation" of the holder's investment in the Target debt in substantially the same form. Specifically, the IRS concluded that the Acquiring debt was a continuation of the Target debt because the Acquiring debt was issued in the reorganization in exchange for the Target debt and had the same terms (other than the interest rate).

Observations and commentary

The determination of whether a corporation's debt is a security is more complex than an objective test based on the length of its term. As noted above, the test prescribed in Camp Wolters is based on (1) the length of the term; (2) the nature of the debt; (3) the degree of participation and continuing interest in the business; (4) the extent of proprietary interest compared with the similarity of the note to cash payment; and (5) the purpose of the advances. The analysis of whether any debt is a security is based on specific facts and circ*mstances rather than a bright-line test.

In making the determination, the authorities consider the factors on the issue date of the instrument. For example, the fact that the debt in Camp Wolters was actually redeemed earlier than the required payment date did not affect the court's assessment that the notes were securities. Similarly, the IRS based its ruling in Rev. Rul. 59-98 on factors present on the issue date of the bonds and not on the fact that the bonds were exchanged for stock with a value substantially less than their principal.

Query whether the conversion feature of convertible debt could be a factor in favor of security status. The treatise quoted above also states, "Convertibility into stock of the issuing corporation would seem to make classification of the debt obligation as a security more likely because of the potential equity participation feature" (Bittker and Eustice at ¶12.11[4]). Furthermore, the court in Neustadt's Trust concluded that convertible debentures were securities, but the extent to which the conversion feature swayed the analysis is unclear. In addition, the court in Neville co*ke specifically considered the fact that the noteholder had an option to convert into preferred stock but concluded that the option did not change anything until it was exercised.

A recurring issue that arises is the determination of whether a debt is a security after a significant modification under Regs. Sec. 1.1001-3. Under Regs. Sec. 1.1001-3(b), a significant modification results in an exchange of the original debt instrument for a new, modified instrument for the purposes of Sec. 1001. Even if the original debt is a security, whether the new instrument is a security could determine whether gain or loss is recognized under Sec. 1001 or whether a nonrecognition provision applies (e.g., Sec. 354).

The IRS provided an exception to the general analysis in Rev. Rul. 2004-78, which provided that there was a significant modification of the target debt and that the new instrument (i.e., the acquiring debt) was a security because it represented a "continuation" of the holder's investment. The court in Neustadt's Trust also seemed to consider the continuation of the holder's investment in principle. However, the extent to which the IRS would apply the continuation principle to fact patterns other than the specific fact pattern in Rev. Rul. 2004-78 is unclear.

Because this issue could have significant tax ramifications (e.g., either a tax-free or taxable exchange to the holder), additional guidance from the IRS in this area would be welcomed by many taxpayers and practitioners.

EditorNotes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.