Purchase Money Note Not Real Debt

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Publication August 11, 2016

A purchase money note given to buy an interest in a partnership that owned geothermal projects was not a real debt, the US Tax Court said in late July.

Lausanne Energy, Inc. bought a Dutch corporation in 1984 that was an original investor in a partnership that owned geothermal projects in California that were developed by Caithness and that had long-term contracts to sell electricity to Southern California Edison. Lausanne invested another $1.08 million in the partnership in 1986.   

By 1991, Lausanne was running up liability for US branch profits taxes on its income from the Caithness partnership that it wanted to avoid. The US collects two taxes on foreign corporations that own interests in US partnerships. First, the foreign corporation is considered engaged in the United States in the same business as the partnership and must pay US income taxes on its income from the partnership. Second, the US, like other countries, collects a second tax at the border when the earnings are repatriated. In this case, the second tax is called a branch profits tax. It is collected in theory when the foreign owner brings its earnings home, but can be levied in practice without waiting for the earnings to be repatriated.

KPMG suggested a way that Lausanne might avoid the second-level tax and that would make better use of US operating losses that Lausanne was unable to use. It suggested selling the partnership interest to a US company, Heimdal Investment Company, Inc., that was affiliated with the original owner of the partnership interest for a note with a term not to exceed seven years with 12% interest and additional “interest” that was essentially a share of excess cash flow distributed by the partnership above the amount needed to pay debt service on the note. The US collects withholding taxes at the border on interest payments, but KPMG suggested the withholding tax would not have to be paid if the interest qualified as “portfolio interest.” It also suggested a way to avoid a separate tax that the US insists US buyers withhold when buying a direct or indirect  interest in any US real property from a foreign seller. Geothermal projects are considered partly real property.

The parties eventually followed through on the plan, but did not implement it exactly as KPMG suggested. Heimdal paid $5 million for the partnership interest by giving a note with a maturity date in 10 years and 12% stated interest. The note required cash distributed by the partnership be used to pay or prepay interest already accrued or expected to accrue during the year. All cash above that was to be split 50-50 between Heimdal and Lausanne. If Heimdal had to contribute any capital to the partnership, then the parties would “consider in good faith” whether the 50-50 sharing of excess cash flow “should be modified to reflect the economic effect of such capital contribution.”

After the 10-year maturity date, the note was extended another three times for a total of seven more years. During one of these extensions, the stated interest was reduced to 6%, but Heimdal continued to pay 12% as if the rate remained unchanged. Sixteen years after the note was originally issued, Heimdal “prepaid” the $5 million principal amount.

The US Tax Court said that the note was not a real debt and disallowed Heimdal’s interest deductions and losses claimed by it as a partner.

It based this on the following conclusions.

There was no real sale of a partnership interest, it said. Everything was done by memos exchanged by tax advisers focused on producing the best tax result. No real negotiation of a sale took place.

Repayment of the debt was contingent on the success of the underlying business. The reason the note had to be extended another seven years is Heimdal did not have enough cash from the partnership to repay the note on time.

Heimdal was a special-purpose entity set up to own the interest. The note barred it from doing anything else. Lausanne retained substantial control over the partnership interest.

The parties behaved like they did not believe the note was a real debt. Heimdal violated the terms by failing to pay interest in 2003 and 2004. No default was called. The interest rate was reduced to 6% in 2006, but Heimdal continued to pay 12% interest.

The case is American Metallurgical Coal Co. v. Commissioner and Heimdal Investment Company, Inc. v. Commissioner. The court released its decision on July 25.


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