Background of the study
Despite the fact that the advantages of the equity over the debt might be clear being in the position to distinguish between equity and debt might not be obvious. The problem of distinguishing between the debt and the equity might be somehow difficult whenever the parties concerned are connected. In the court case between NA General Partnership and Subsidiaries, the court evaluated the advances which were made by the parent company to the NA General Partnership and Subsidiaries (George, 2013). Based on the different factors of the tax payers’ situation the court in the case concluded that the advances were actually debt. In the case, the court paved way for the payments to be considered as deductibles instead of the non-deductible dividend payments. The work will tend to evaluate a debate in accounting which argues that the redeemable preferred stock and century bond are debt or equity. In addition, according to section 385 there are different factors which determine whether the redeemable preferred stock or century bonds are debt or equity.
Factors determining whether to classify redeemable preferred stocks and century bonds as either debts or equity
In circumstances where a corporation or an organization is believed to be thinly capitalized, the IRS usually considered the debt to be an equity interest. Therefore, it ends up denying the organization the tax advantages as far as the debt financing is concerned. Thin capitalization of a corporation is believed to occur when the debt of the shareholders is believed to be high in comparison to the shareholders equity. Just in case the debt instrument in question many have many characteristics of the stock, it may be considered for tax purpose of that stock (Horace, 2012). In this circumstance, the interest payment and the principle are treated as dividends. Section 385 in the taxation code normally highlights different factors which might be used to determine whether the redeemable preferred stocks and century bond are either equity or debt. The section usually give power to the Treasury to determine the Regulations which provide definite guideline of differentiating whether the redeemable preferred stocks and century Bond might be treated as equity or debt. The fact that most treasury have not yet come up with these differentiation guidelines, the taxpayers currently rely on judicial decisions to establish whether the debtor-creditor connection usually exists. Based on the court decision the redeemable preferred stock and century bond are classified as equity.
According to the court and the code tax section 385, in determining whether the redeemable preferred stock or the century bonds are either debt or equity, the investor should establish whether the debt instrument is in appropriate nature. An open account advance according to the tax code section is normally and easily treated as a contribution to capital rather than a loan or a debt (Kelvin, 2010). The investor also has the function of establishing whether the debt instrument posses a reasonable interest rate and a definite date of maturity. Whenever the investors’ advances do not provide interest, the return from the redeemable preferred stock may be regarded as a share of the profit. The lender who has no connection with the corporation would tend to be unwilling to lend its fund with the corporation without a due data stated. The redeemable preferred stocks are deemed to be equity because they usually have a fixed dividend payout. Both the redeemable preferred stock and century bonds are usually treated as equity because they are usually considered to be shareholders’ equity in the corporation’s balance sheet. The redeemable preferred stock normally has a fixed dividend which makes them fixed income securities
Whenever the debts are subordinate to the liabilities both the century bond and the redeemable preferred stocks might be treated as equity. In cases where the equity is believed to be subordinate to the liabilities of the corporations then both the redeemable preferred stock should be treated as debt. In accounting, subordination tends to do away with great traits of creditor- debtor association. At this situation, the creditors should be in position to share the profits with the other shareholders of the organization or the corporation just in case of liquidation or dissolution. In addition, the subordination process usually breaks down the basic characteristic of the creditor in a corporation as he is denied the authority to demand for payment at a fixed maturity date (Horace, 2012). In other circumstances the redeemable preferred stock or the century bond might be treated as equity depending on the proportion of the dent of the stock held by the shareholders or the creditors. Whenever the redeemable stock and the century bonds are help at the same level, it become difficult for the corporation to establish whether its distributions are in the form of dividends or the interest and they are therefore treated as equity.
Instances where the funds obtained by the company are used to for capital asset acquisitions or financing the initial operations of the organization they might be treated as equity where as the funds obtained by the organization to fund its day to day operations are usually considered to be debt (Kelvin, 2010). The funds which are used to fund the initial acquisition of the initial capital assets or for starting the operation of the corporation must always be obtained from the equity investment and must at all the time be treated as equity in the corporation balance sheet. On the other hand, the capital obtained in funding the day to day operation should be regarded by the organization as a liability to the company and must be treated as a debt financing.
In determining the appropriate way to classify the redeemable preferred stock and the century bond in term of whether they are equity or debt the corporation or the investor must evaluate whether the corporation either has a high ratio of shareholders equity or shareholders debt. In circumstances where the corporation has a higher ratio of debt to equity, both the redeemable preferred stock and the century bond are normally treated as debt (Yvonne, 2009). On the other hand, whenever the shareholder ratio of the equity is higher than the debt ratio, both the century bond and the preferred stock are treated as equity in the corporation’s balance sheet
Furthermore, under section 385 of the code of taxation, the IRS has the mandate to classify both the redeemable preferred stock and the century bond as either wholly equity or debt or partly equity or debt. The proposal of the IRS is appropriate because the redeemable preferred stock or the century bond might sometime be hard to be classified as either debt or equity (Horace, 2012). The flexibility of the approach also provides an opportunity for the IRS to be in the right position to solve some of the problems which might be encountered by the corporations which trade publicly. The dissimilarity between the debt and equity financing usually involves the consideration of the tax treatment of the worthless securities and stock in comparison to the application of the bad debt. In circumstances where both the redeemable preferred stocks and the century bonds are treated as capital to the corporation they are usually considered to be equity but when both of them are borrowed to finance other operations after the initial investment they might be regarded to be debts because they seems to be liability to the corporation (Jane, 2011). The factor of payment depending on earning must also be put into consideration in determining whether the redeemable preferred stock and the century bonds should either be classified as either equity or debt. Given the fact that lenders would never advance loans to corporations which would never be successful in the future, the corporation redeemable preferred stock and the century bonds would eventually be regarded as bonds.
Whenever the redeemable preferred stocks and the century bonds are treated as capital assets to the corporation, the capital loss from both of them are considered to materialize at the final day of the taxable year and they are regarded to be worthless (Kelvin, 2010). When both the redeemable preferred stock and the century bonds have already declined in value there are no deductibles which are allowed onto them. The idea of claiming on the assets worthlessness is based upon the investors or the corporation claiming on the loss made. Taxable exchange or sale might be recognized worthless depending on the dispose of the bonds or the stocks. The tax influence is usually disallowed if the exchange or the sale is associated to the close members or the family or if the funds were obtained from the close associates of the organization.
Conclusion
Determination of whether the redeemable preferred stocks or century bonds are either debt or equity is usually a difficult task and necessitates the corporation or the investors to determine whether: the debt instruments are under the appropriate form, they bear a reasonable rate of interest and maturity date and the debts are paid timely. The investor or the corporations would also put into consideration on whether the payment is a reliant on earnings, whether the debts are inferior to the other liabilities and whether the possession of the stock, whether the debt are balanced, whether the funds obtained we used to finance initial capital for the business and whether the company has a high ratio of shareholders equity to debt.
References
George, K.(2013).A careful evaluation may be required in distinguishing the debts and equity. Cambridge university press.
Kelvin, A.(2010).Century Bonds: Debt or Equity Securities. Oxford university press.
Jane, S.(2011). Tax deductible equity and other hybrids in the United States economy. New York publishers.
Horace, E.(2012). Perpetual and Super-Maturity Debt Instruments in the U.S. Taxable Income journal. Vol.4(1), Pp.21-33.
Yvonne, U. (2009). Insights on Accounting for Debt and Equity Transactions in the United States code of taxation. Retrieved from: https://www.law.cornell.edu/uscode/text/26/385
