In the matter of VHC, Inc. and Subsidiaries (“VHC”) v. Commissioner of Internal Revenue (“IRS”), the IRS identified more than $32 million of deficiencies in VHC’s federal income tax liabilities for the tax years 2004-2013 . For the tax years at issue, VHC claimed deductions related to bad debts that it claimed were owed by various related parties . It was VHC’s position that it was entitled to business bad debt deductions for the years at issue for advances made to a related individual and his businesses which became partially worthless during those years . The IRS, however, claimed that VHC failed to establish that such advances were debt in substance.
In its review in this dispute, the Tax Court analyzed whether the advances represented bona fide debt, considering 14 “objective factors…to determine the parties’ intent and whether a bona fide loan occurred…,” asserting that “no single factor is dispositive.”
To this end, the court relied on the factor analysis identified in Dixie Dairies Corp. v. Commissioner. While considering certain factors indicating the formal documentation of the advances, including the names given to the various promissory notes and documentation of fixed maturity dates, the court also evaluated factors indicative of the economic substance of the advances to ascertain the intent of the parties to these transactions. The factors relating to the economic substance of the transactions considered by the court include:
Based upon its analysis of the various factors, including those highlighted above, the court determined that VHC’s advances to the related parties did not represent bona fide debt, and that VHC did not reasonably expect repayment of the advances. Accordingly, the court concluded that VHC was not entitled to bad debt deductions for the advances made to the related parties.
Relying on the 14 factors set forth in Dixie Dairies Corp., the court in VHC performed a sophisticated and informative analysis of the intent of the parties pertaining to certain advances made by the petitioner. The objective factors established in Dixie Dairies Corp., and other similar factor tests, not only assist in the inquiry into the intent of the parties by considering the formalities of such funding arrangements, but also provide insight into their economic substance. While no single factor is dispositive in the court’s inquiry into the parties’ intent, the factors highlighted above provide unique insight into how the court views the economic indicia of debt, and why those features of the VHC advances disqualify the petitioner’s treatment of such as indebtedness.
Stout assists clients through all phases of litigation: pre-litigation planning, discovery, mediation, trial/arbitration, and remediation in a variety of disputes, including those involving the characterization of debt instruments and promissory notes. Stout’s professionals are regularly retained to provide expert financial and economic analysis of the features of debt and equity instruments at issue in bankruptcies, complex commercial litigation, shareholder disputes, and tax controversies, among other engagement types.