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.

Generally, the court observed, an inordinately postponed due date, or the absence of a fixed maturity date, “weighs in favor” of characterizing an advance as a capital contribution. But despite the fact that the payment of the notes was contingent upon the existence of surplus funds in excess of $12,500, the District Court found that this provision did not convert the notes from debt to capital. This finding, the Court of Appeals observed, “accords with reality,” in view of the fact that the instrument was actually repaid two years after the advance of the funds: repayment in that relatively brief time frame is a clear indication that an early maturity date was contemplated.

Further, the court noted that “the restriction on payment of surplus notes to a time when surplus funds exceed a certain amount is required by state law.” Moreover, the existence of “proportionality,” although an “equity factor,” was not dispositive. Proportionality, in this case, refers to the holders of the surplus notes owning the corporation’s equity in the same proportions in which they held the notes.

With the exception, however glaring, of the contingency clause, the court concluded that the surplus notes had all of the “legal indicia” of debt. That is, they were in written form, for a certain sum, with fixed interest payments, confer no voting rights, and contain no provision for subordination to general creditors or restrictions against transferability. The court noted that the “reasonable interest provision” of 5% also lends credence to the taxpayer’s intent to create a debt, as does the very low debt-to-capital ratio the corporation exhibited.

Accordingly, in the court’s view, the transaction “lacked the aura of high-risk capital investments,” and the surplus note, therefore, was properly classified as indebtedness for federal income-tax purposes. This case supports the notion that surplus notes that are imbued with the formal indicia of debt will be respected as such for tax purposes. That would be the case even though the instrument is subordinated, albeit not expressly, held by the same persons, and in the same proportions as the issuer’s stock, and does not — due to its unusual terms — represent an unconditional promise to pay a sum certain on demand or on a reasonably proximate maturity date.1

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1 See also Jones v. United States, 659 F.2d 618 (5th Cir. 1981); in 1954, the taxpayer and others organized an Alabama insurance company known as Associated Doctors Health and Life Insurance Co. AD. AD executed surplus capital notes. The court concluded that the notes represented valid indebtedness and not disguised equity capital. The court noted that the instrument was labeled “surplus capital notes,” nomenclature common in the insurance business to refer to a debt executed in contemplation of applicable state surplus capitalization requirements. The notes were subordinated but the court played down this fact — subordination, the court observed, was superimposed by state laws that sought to protect the policyholders. We cannot, the court concluded, hold that subordination destroyed the debt aspects of the transaction. Moreover, here, the corporation was at all times adequately capitalized. The critical factor, the court concluded, is that state regulations and laws are the reason the parties to this transaction structured it the way they did. The fact that an insurer seeking to structure a debt transaction is “severely limited in his options,” as well as the extent to which the transaction has paralleled the required form, led the court to conclude that the instruments, in the final analysis, represented bona fide indebtedness.




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