Hybrid Debt Survives Test Case

Hybrid Debt Survives Test Case | Norton Rose Fulbright

May 01, 1999 | By Keith Martin in Washington, DC

The debt is called MIPS, or monthly income preferred securities. MIPS have rapidly displaced preferred shares in corporate capital structures since they were first introduced in 1993.

MIPS offer some of the same financial flexibility as preferred stock. They have long terms to maturity, they can bear a fixed or floating return, they are deeply subordinated, ranking just above common shares, and a company using them has the option of deferring payments for up to 18 months to five years during periods when the company is short on cash.

MIPS are treated effectively as debt for tax purposes. Thus, earnings paid to holders are deducted as “interest.” However, companies record them as equity for book purposes, the rating agencies assign them largely equity treatment, and the Federal Reserve Board has approved at least some forms of MIPS as tier I capital for banks. This makes the instruments a valuable tool, given the lengths to which corporations go to keep debt off their balance sheets to preserve borrowing capacity.

MIPS go by various acronyms. MIPS is the term for a product developed by Goldman Sachs. The Merrill Lynch product is called TOPRS. Other investment banks have similar instruments with other names.

The IRS said in 1994 that it would “scrutinize” MIPS wherever it found them. The Clinton administration then went further by proposing to Congress in 1996 and again in 1997 that corporations not be allowed to deduct interest paid on instruments with terms of 15 or 20 years or more unless the instrument is shown as debt on the balance sheet the corporation files with the US Securities and Exchange Commission. Congress has not acted on the proposals. At least one early issuer of MIPS — Enron Corp. — has tentatively settled a case it filed in the US Tax Court after the government denied it interest deductions.

With that background, it was perhaps surprising to see the IRS national office release a “technical advice memorandum” in April that let a company deduct payments to MIPS holders as interest. A technical advice memorandum is a MIPS are treated effectively as debt for tax purposes but companies record them as equity for book purposes ruling issued by the national office to settle a dispute between a taxpayer and an IRS field agent stemming from an audit. The agent sought to disallow the company’s deductions. The ruling does not bind the government in future cases, but it is still helpful.


The MIPS in the ruling took the following form. The taxpayer — call it “Corporation A” — formed an LLC, or limited liability company, in a foreign country. Corporation A owned the common stock of the LLC. Over the next few years, the LLC sold three classes of preferred shares to the public. The first two were listed on the New York Stock Exchange. The third was denominated in a foreign currency and listed overseas.

The LLC used the funds raised by the shares to onlend to Corporation A.

One set of MIPS paid a fixed dividend each month on the share price of $25. The next paid a fixed dividend changing to floating after a few years. The last set of MIPS simply accumulated dividends at a fixed rate and paid at the end like a zero-coupon bond. The dividends were cumulative. To the extent the LLC lacked the cash to pay full dividends, it made them up later with interest. Corporation A was free to redeem the MIPS at any time after year X at the share price plus any accumulated but unpaid dividends. The shares had priority over the common shares that Corporation A owned in the LLC.

The rates, maturities, payment dates and other features of the loans from the LLC to Corporation A matched the MIPS.

Unfortunately, the rulings don’t give the maturities for the different instruments. Early MIPS issues had terms of 50 to 100 years but maturities on more recent issues were cut back to under 15 years after the Clinton proposals.

Corporation A could defer paying interest to the LLC on the first loan for up to 18 months at any time. It could delay up to five years on the second loan. The third loan did not require any payments of interest until maturity.

The LLC was also free to relend the interest it collected to Corporation A, provided Corporation A remained a good credit risk.

The MIPS holders had the right, after a default on any loan, to enforce the loan directly by appointing a trustee to act for the MIPS holders in place of the LLC.

The loans ranked ahead of common shares and trade creditors, were pari passu with each other, but were subordinate to all other lenders, including such lenders making loans in the future.

Book Equity

The IRS said Corporation A “described the loans as debt in filings with the Securities and Exchange Commission and other government agencies.” However, the loans disappeared for book purposes because Corporation A prepared consolidated financial statements combining its results with those of its subsidiary, the LLC; intercompany assets and liabilities are ignored under GAAP accounting. The books simply showed the preferred securities issued by the LLC as a “minority equity interest in [a] subsidiary.” The rating agencies assigned Corporation A some equity credit for the financing structure since the structure left the company with significant financial flexibility compared to commercial paper or longterm senior debt. The ruling does not say the percentage of equity credit. However, credit is usually roughly 70%.


The IRS agent wanted on audit to collapse the structure and treat the MIPS also as equity for tax purposes. The IRS national office said no.

It cited the following as key factors pointing to treatment of the loans from the LLC to Corporation A as debt. First, there was “an unconditional promise to pay a sum certain . . . at a fixed maturity date that is in the reasonably foreseeable future.” This is a loan by definition. Although Corporation A had the ability to extend each loan by relending the interest payments to itself, there was a reasonable limit and the right was not unconditional. Second, the holders of the MIPS could bypass the LLC and enforce the loans directly against Corporation A. This was important because Corporation A was otherwise in control of the LLC. Third, the loans ranked ahead not only of shareholders, but also trade creditors and unsecured lenders. Fourth, Corporation A was not thinly capitalized.

The IRS explained away the inconsistent characterizations for tax and book purposes. It said rating agencies often assign partial equity credit to long-term loans that are clearly debt for tax purposes. As for book treatment as equity, the IRS said that if the books had been prepared for each company on a stand-alone basis, the loans would have been visible as debt.

The agency said the MIPS would have been debt if issued by Corporation A directly. It discussed whether to collapse the two transactions — issuance of MIPS and onlending of proceeds — on grounds that the two legs lacked economic substance, but decided the two legs had substance and that the tax results would have been the same anyway.

by Keith Martin, in Washington