Different Approaches To Recharacterizing Debt to Equity

Whether an investment is determined to be debt or equity can have significant impact in tax and bankruptcy situations.  However, the contextual setting for addressing these issues is very different in bankruptcy cases from tax matters.  Tax cases frequently involve solvent companies where the focus is whether a transaction between the investor and the corporation should be deemed to be a debt that would generate a tax benefit to the investor.  In contrast, in a bankruptcy case, the issue is frequently whether the claimant/investor who provided a “loan” to a financially distressed enterprise should be treated on par with other creditors or subordinate to them as a holder of equity.  Nonetheless, the law of recharacterization of debt to equity, as applied in bankruptcy cases, has generally been imported from federal tax law.

The term “recharacterization” can be viewed as a misnomer since the debt-versus-equity inquiry is not really an exercise of recharacterizing a claim, but of recognizing the advance’s true character.   Under recharacterization, the substance of the transaction will govern over form.

The Courts of Appeals are now viewing the doctrine of recharacterization in bankruptcy cases through different lenses.  Some circuits apply bankruptcy law and others apply state law.  The conclusions reached, however, are likely to be the same in most cases regardless of the approach taken.  The majority approach applies a federal test patterned on tax cases.  The more recent approach adopted by the Fifth Circuit in Lothian Oil and the Ninth Circuit in Fitness Holdings requires the application of state law.  The alternative approaches, in most instances, may amount to a distinction without a difference.  Most likely, multi-factor tests adopted from federal tax cases will continue to be applied under either approach.  Further, recharacterization is a question of fact that will continue to be determined on a case-by-case basis.



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