Tax Court Dissects Complex Acquisition Transaction With Senior and Subordinated Debt Characterization in Issue (10/27/21)

In Tribune Media Co. v. Commissioner, T.C. Memo. 2021-122, here, issued yesterday, the Tax Court addressed a complex acquisition of the Chicago Cubs and held (in a 127 page opinion), that

• Certain debt (subordinated debt (called “sub debt”)) was equity rather than debt for tax purposes (slip op. 56-90.)  The result of holding the sub debt to be equity was that, under the partnership disguised sale rules, gain was recognized to the extent of the sub debt.  Specifically, and more precisely, since the parties agreed that the partnership disguised sale rules applied, the Court held that the treatment of the sub debt as equity meant that the exception for debt-financed distributions did not apply to that debt.  (This aspect of the transaction planning had been designed to qualify as debt-financed distributions.)  This holding turned upon the debt-equity distinction familiar to tax practitioners and even students of tax law.  The Court held (Slip op. 90) that “Although the sub debt had the superficial appearance of bona fide debt, it more closely resembles equity.”

• The senior debt in the transaction was bona fide recourse debt that could be allocated to support the debt-financed distribution exception to the disguised sale rules.  (Slip op. 91-119.)  With respect to the senior debt (slip op. pp. 118-119) the Court concluded (Slip op. 118-119, footnote omitted):

The Cubs transaction was a disguised sale in both form and substance. The economic reality of this transaction lies squarely within the intent of the disguised sale statute. The parties to the transaction formed a bona fide partnership that operates the Cubs franchise with assets contributed by Tribune. And the partnership in fact distributed cash to Tribune. This transaction also substantively fits into the debt-financed distribution exception for a disguised sale, receiving the distribution tax free up to the amount of the senior debt guaranteed by Tribune. CBH borrowed the senior debt, and Tribune guaranteed the senior debt. When such a transaction is explicitly provided for by Congress and followed by a taxpayer in both substance and form, we will not recharacterize it.The doctrine of substance over form is applied to prevent taxpayers from mislabeling transactions to achieve a desired tax consequence. Petitioners did not mislabel the transaction here; the economic substance of the Cubs transaction is a disguised sale with a debt-financed distribution, a structure contemplated by both the statute and the regulations.

• The Court finally held (pp. 119-127) that certain expenses paid to a third party must be capitalized rather than expensed.  The third party (Utay) had been involved earlier in the bidding but, after the negotiations stalled, Tribune requested that he re-engage.  Ultimately Utay did not do the transaction, but Tribune agreed to pay $2.5 million in expenses, mostly legal fees, “to reengage in the bidding process for the Cubs after negotiations with the Ricketts family stalled.” (See p. 119.)

The first two holdings applied the partnership disguised sale rule and the debt-financed transaction exception.  Bona fide debt for tax purposes is required, and the party receiving the distribution must be ultimately “liable” for the debt, at least theoretically under partnership tax constructs.  In the first holding for the sub debt, bona fide debt for tax purposes did not exist, hence the distribution triggered gain.  In the second holding for the senior debt, bona fide debt for tax purposes did exist and was properly allocated, hence the distribution did not trigger gain.

The Court did not decide any penalty issues in this opinion.  The Court noted that penalties were involved for both taxpayers involved because the notice of deficiency for one had asserted accuracy related penalties and the FPAA also asserted accuracy related penalties.  (See Slip op. 37-39.) In both cases, the petitioners alleged that the IRS had not met the written approval requirement of § 6751(b).  In an earlier opinion, Tribune Media Co. v. Commissioner, T.C. Memo. 2020-2, the Court held that the § 6662(h) penalty for gross valuation misstatements penalty had been timely approved, but had the issue was still open as to the other accuracy related penalties.  The question as to whether the penalties actually apply has not been determined.

JAT Comments:

1. In making the holding that the sub debt was equity, the Court addressed the factors considered in making a debt-equity distinction.  One of those factors is the parties’ intent.  The parties labeled the sub debt as debt.  But that does not mean that they even intended it to be debt.  The Court held (Slip op. 75) regarding the intent factor:

            This factor indicates equity. While the parties wanted the sub debt to have the appearance of debt for tax purposes, they intended the sub debt to function economically as equity. The sub debt needed to give the impression of debt for Tribune to achieve its desired tax outcome. And it is clear that Tribune made consistent payments according to the terms of the sub debt. But despite petitioners’ contentions otherwise, the true function of the sub debt was that of an equity investment.

2. It is not clear from the decision as to how much was in issue on the debt.  The notices were in large amounts (see Slip op. 37-38), most of which seems to be attributable to the debt issues.  But since the court split the debt issues, the precise amount of the loss or win (depending upon how characterized) must await the calculations for the decision document. 

3. The transaction and specifically its "debt" (real or claimed) components was very complex.  But, the Court was able to dig into the substance and apply the rules in a measured way.  I am not saying that I believe the Court correctly applied the rules.  The debt-equity distinction is notoriously indeterminate in many cases.  I imagine that, in most cases, different courts could slice and dice the factors and reach different conclusions on the same set of facts.  In this case,  if I had to make a call on the Tax Court's debt conclusions here, I would think that the Court's holding for the sub debt is more solid than the holding non the senior debt.  But that is perhaps the worst form of speculation because I have not read the record or heard the witnesses (particularly the expert witnesses) and haven't even studied the opinion in great depth.