Are Surplus Notes Disguised Equity?

If surplus notes look like debt, and act like debt, it's reasonable to assume the courts will treat them like debt for tax purposes.

In connection with a settlement related to credit derivatives and other structured financings, Ambac Assurance Corp. (AAC) announced in March that it will transfer some $2 billion principal amount of “surplus notes” (along with $2.6 billion in cash) to certain counterparties. In an 8-K filing, Ambac Financial Group Inc., AAC’s parent, warned that these surplus notes might be regarded by the Internal Revenue Service as equity capital.

Ambac Financial noted that if the recharacterized notes represent more than 20% of the total value of AAC’s stock, the result will be the deconsolidation of AAC from the rest of Ambac Financial’s consolidated group. In that event, AAC’s net operating losses will no longer be available to reduce the taxable income, and hence the tax liabilities, of the consolidated group.

In addition, if the notes are regarded as equity, and they represent more than 50% of the total value of AAC’s stock, AAC will experience an “ownership change” within the meaning of the Internal Revenue Code, specifically Section 382(g). As a result, for any taxable year ending after the change date, the amount of taxable income that may be offset by AAC’s prechange NOLs will be severely limited. However, based on the sparse case law addressing the question of whether surplus notes constitute disguised equity, the odds of the IRS successfully asserting that AAC’s surplus notes constitute equity capital appear to be rather slim.

In Harlan v. United States, 409 F.2d 904 (5th Cir. 1969), the taxpayer — W. Larry Harlan and his wife, Mary Jane Harlan — organized Union Bankers’ Life Insurance Co. on March 9, 1961. The couple paid $25,000 in exchange for all of the capital stock of Union Bankers’ Life. Then the taxpayers advanced an additional sum of $12,500, in return for which they were issued an interest-bearing surplus note, payable on demand. However, the note contained a clause that it shall mature and become payable only at such time or times as the surplus funds of the corporation exceed $12,500 and only to the extent that such surplus funds are in excess of $12,500.

Therefore, the note did not embody an unconditional promise to pay a sum certain on demand or on a reasonably close maturity date. In fact, on April 8, 1963, Union Bankers’ Life repaid the taxpayers the sum of $12,500 represented by the surplus note, plus interest.

Willens quote 4-26-10

The IRS contended that the surplus note simply represented a contribution to capital, and that the distribution to the Harlans was not a nontaxable repayment of loan principal; rather, it was “equivalent to a dividend.” However, the U.S. District Court found that the surplus notes were, indeed, valid indebtedness. This holding was affirmed by the U.S. Court of Appeals for the Fifth Circuit.

A claim that is good “only against surplus” is, the IRS noted, subordinated to all liabilities of the issuer since surplus exists only to the extent that assets exceed liabilities. The court noted that, even if the notes had been expressly subordinated to other indebtedness, this factor alone, however incriminating, would not have been determinative.


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