Hewlett-Packard was handed a recent loss in Tax Court when its preferred equity in a foreign corporate special purpose vehicle (SPV) was recast as debt.  Consequently, HP was denied an indirect foreign tax credit as well as a capital loss on the equity when sold.

So, what exactly happened here?

Historically speaking, HP fell into a classic tax question: was the subject investment debt or equity?  The answer is not always so easy to discern.  Believe it or not, The Internal Revenue Code itself does not contain a general definition of the term “indebtedness” or “equity.”  Instead, courts that have considered the debt versus equity issue have repeatedly stated that the question whether an advance of funds is debt or equity is a question of fact to be decided on the basis of all the facts and circumstances.  Courts typically consider a list of factors that are to be taken into account in resolving this issue.

Here, the court held that HP’s preferred equity of a foreign corporation was debt because there was a high level of economic and legal certainty that HP would receive a prescribed dividend and that HP’s investment would be as safe as a bank deposit.  The court also noted that HP held a right to put the stock to its fellow shareholder in the seventh year of the investment, which the court treated as a put to the issuer.

The alarming thing about this case is that the court’s ruling relied so very much on the very aspects that typically make SVPs attractive to investors: namely, the investment’s safety and security.  SPVs are often specifically designed to constrict both their investment options and their ability to incur debt.  But according to the court’s ruling the fact that “HP was essentially assured of the return on its investment” took its SPV interest out of the world of equity.

Going forward, international issuers and investors will need to particularly mind the economic security and exit certainty elements of a planned SPV.  When combined, these two aspects, meant to cater to conservative investors, may in fact prove too good to be true.