November 27, 2011
Tax Doctrine in Corporate and Commercial Law
Posted by Diane Lourdes Dick

Although I teach, write and practiced predominantly in corporate and commercial law, I also have an LL.M. in Tax. Granted, my LL.M. coursework largely focused on business taxation, and therefore falls squarely within my interests. Nonetheless, given that tax and corporate/commercial law are treated as separate legal disciplines, I see tremendous opportunities for comparative and interdisciplinary analysis among tax, corporate and commercial law.

For instance, I find it intriguing that courts employ highly divergent decision-making approaches in these realms. In the tax realm, courts tend to focus on the actual economic arrangement of the parties, in an effort to identify economic substance rather than mere contractual form. Courts presiding over tax cases tend to utilize more expansive and contextual interpretive methodologies, and routinely scrutinize objective and subjective intent and other "facts and circumstances." These approaches stand in contrast to the dominant, textualist interpretive paradigm in corporate and commercial law, which relies almost exclusively upon strict interpretive norms (such as rules of contract interpretation) to construe written agreements.

To be sure, these divergent methodologies reflect the differing goals of tax, corporate and commercial law. While jurisprudence across all three disciplines emphasizes the need for certainty, uniformity and predictability in the law, tax law remains manifestly skeptical of the party autonomy that corporate and commercial law strive to protect. Courts presiding over tax cases are often called upon to examine possible crimes against the public fisc; in contrast, courts presiding over corporate and commercial law cases are generally called upon to manage disputes among sophisticated parties to voluntary, utility-maximizing arrangements.

Yet despite these distinctions, courts are increasingly importing tax doctrine into the corporate and commercial law context. A classic example is the "debt recharacterization doctrine." In the federal income tax realm, considerably high stakes turn on the proper classification as debt or equity of a person's interest in a corporation. Generally speaking, the characterization of the investment as a loan means that payments of interest will be includible in gross income. In contrast, to the extent the investment is deemed to be an equity capital contribution, then the principal amount of the investment must be capitalized into the investor's basis in the corporation's stock. The tax treatment of any repayment will be determined pursuant to rules governing corporate distributions, with any amounts deemed to be a dividend includible in gross income. In light of these differing tax consequences, courts have developed multi-factor, highly facts-intensive and contextual analyses to recharacterize a purported debt instrument into an equity investment, and to reassign tax consequences accordingly.

The debt recharacterization doctrine was subsequently imported into the bankruptcy realm. In that context, if a court determines that an investment is equity rather than debt, then the claim will be treated as an equity ownership interest in respect of which no distribution of corporate assets can be made unless creditor claims are satisfied. Even within the less formalistic realm of bankruptcy, the importation of the debt recharacterization doctrine is a major departure from dominant jurisprudential norms. As a general matter, bankruptcy courts look to state contract law when matters arise under private agreements and there is no statutory law on point. For this reason, although bankruptcy courts have wide latitude to exercise legal and equitable powers, most matters that arise in respect of contracts are construed in accordance with state contract law, including rules of contract interpretation.

Of course, the bankruptcy context, much like the tax realm, may provide inherent justifications for the application of more expansive judicial methodologies. In particular, courts applying the debt recharacterization doctrine in bankruptcy matters are frequently responding to the plight of third party creditors who may recover less due to the crafty maneuvers of shareholders.

More recent cases demonstrate a willingness to import tax doctrine into corporate and commercial law even where the justifications for doing so are less obvious. For instance, in Coughlan v NXP BV, C.A. No. 5110-VCG (Del. Ch. Nov. 4, 2011), the Delaware Court of Chancery applied tax law's "step transaction doctrine" to an action brought by a stockholder representative seeking to construe terms of a merger agreement. In tax law, the step transaction doctrine is applied where parties engage in multiple transfers to circumvent rules that would apply to a more direct transfer. In Coughlan, the merger agreement provided that, in the event of a change in control of NXP or of pertinent corporate assets, the person acquiring NXP or the assets would be required to accelerate certain contingent payments or assume the obligations. The stockholder representative argued that NXP's two-step transfer of assets to a joint venture amounted to a change in control. NXP argued that it engaged in two transfers that were each permitted under the merger agreement. The court applied the step transaction doctrine, finding that the two transfers should be analyzed as a single transaction that ultimately effectuated a change in control.

The court explained that the step transaction doctrine has been imported into the Delaware corporate and transactional context as well as the bankruptcy realm. It cited a 2007 case construing provisions in a partnership agreement, whereby the Court of Chancery defended application of the doctrine: "I see no reason as a matter of law or equity why the step transaction principle should not be applied here. Indeed, partnership agreements in Delaware are treated exactly as they are treated in tax law, as contracts between the parties." Twin Bridges Ltd. P’ship v. Draper, 2007 WL 2744609, at *10 (Del. Ch. Sept. 14, 2007).

To be sure, such a rationale denies fundamental differences in tax, corporate and commercial law. However, in terms of judicial decision-making methodologies, the increased application of tax doctrine to cases in the corporate and commercial law realm may signal a movement away from formalism, and a rising interest in identifying the actual economic arrangement of parties as opposed to merely construing contractual form. Indeed, the Court of Chancery articulates this point in Coughlan, issuing words of caution to parties who rely on the written word in their business planning and legal advocacy: "transactional formalities will not blind the court to what truly occurred." Coughlan, C.A. No. 5110-VCG at 23.

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