Luís Calderón Gómez asks the question, “Whose Debt Is It Anyway?,” to frame his analysis of a situation that, while common, remains understudied and undertheorized: the tax treatment of debt co-obligors.
Calderón Gómez’s initial contribution is to demonstrate that there is, in fact, a problem. Co-obligated debt offered by corporate issuers alone is “in the hundreds of billions” of dollars under a “conservative estimate” based on SEC documentation. Yet, tax law generally assumes a conceptual paradigm “where one creditor lends money to one borrower.” Calderón Gómez begins the article by illustrating the inconsistent and incoherent tax treatment that results when a loan arrangement departs from this paradigm.
In the course of highlighting the uncertainties of the tax treatment of co-obligated debt, Calderón Gómez uses case law and administrative authorities to construct a descriptive framework “categorizing the problems the law faces and the different rules available to legal authorities to resolving such problems.” He focuses on three contexts—debt modification, interest deductions, and cancellation of indebtedness income—and identifies three recurring and interrelated problems that arise in these contexts.
First, the cases and administrative authorities take “radically inconsistent approaches” in the extent to which substance should control over form (and vice versa). Luís Calderón Gómez gives the example of the debt modification regulations, which determine when an amendment to a debt obligation results in a taxable exchange. These regulations appear highly form-driven, but they do not define key terms. The regulations specify that the substitution of a new “obligor” on a recourse debt is generally a significant modification, but the addition or deletion of a “co-obligor” or a “guarantor” is instead generally tested by assessing whether there has been a change to payment expectations. Calderón Gómez shows that a close review of IRS rulings reveals that the agency has used the regulations’ failure to define basic terms like obligor, co-obligor, and guarantor to inject substantive analysis and to “blur[] the line” among these categories.
The second recurring problem is a tendency for courts and administrative authorities to demonstrate a “strong aesthetic preference” for a single, “true” obligor instead of dealing with the messy reality of multiple obligors and guarantors. In the context of cancellation of indebtedness income, Calderón Gómez demonstrates how certain court decisions fail to deal directly with joint obligations and instead superimpose the one-debtor paradigm in order to assign all of the income to one obligor, typically the last obligor standing.
Whether and how legal authorities should handle contribution and reimbursement agreements among obligors is the third recurring problem. For example, if a co-obligor pays the interest on a loan but has a contractual right to be reimbursed in whole or in part by another co-obligor, should that payor still be able to take an interest deduction (to the extent otherwise available)? Calderón Gómez points out that courts tend to favor the approach of focusing on whichever co-obligor actually makes the payment, but depending on the situation, may show “unease at the tax results” if a nominal co-obligor has no ultimate responsibility once reimbursement rights are taken into account.
After providing a framework that reveals the puzzle of co-obligated debt, Calderón Gómez advances reform proposals. As an initial step, he recommends a uniform approach to identifying co-obligors and distinguishing them from guarantors. To be a co-obligor, two characteristics would control: (1) the creditor would need to have “a direct right to repayment against the party in question under the contract,” and (2) the obligor would need to “bear[] at least some portion of the ultimate liability of the debt as a result of their contractual obligations.”
All those identified as co-obligors would be treated as primary obligors without distinguishing among them by, for example, using a fact-and-circumstances approach. While the “IRS and the courts should focus on the contracts,” tax authorities and courts would remain able to rely on other doctrines, such as a substance-over-form inquiry into whether an arrangement is debt at all. Calderón Gómez persuasively argues that this first step would resolve substantial ambiguity, would be administrable, and would consistently balance form and substance.
As a second proposal, Calderón Gómez would allocate any tax consequences arising from the debt by presuming that the co-obligors have “equal shares of liability on the debt,” but he also would permit express contribution and reimbursement agreements rebutting that presumption. In order to avoid whipsawing the IRS via duplicate interest deductions or other benefits, taxpayers would be required to disclose such agreements contemporaneously with the debt issuance; as Calderón Gómez points out, this approach is similar to that required for identifying hedging transactions. In contrast to his first proposal, “legal authorities should look beyond contracts when determining whether the underlying debt allocations have substance for purpose of allocating the tax consequences on co-obligated debt.” This would include an inquiry into whether a co-obligor “has the wherewithal to be a ‘true’ co-obligor with respect to its portion of the debt.”
As a final proposal, Calderón Gómez recommends adding an approach for handling modifications vis-à-vis the co-obligors while retaining the current debt modification regulations for changes vis-à-vis the creditor. His proposal “would center on whether there was a transfer of value from one obligor to another,” with the resulting consequences driven by general tax principles and rules. For example, depending on the context, a transfer from one co-obligor to another could be treated as compensation, a gift, or a dividend.
In the concluding sections of his article, Calderón Gómez shows how his proposals operate both by providing a stylized example and by examining their potential application in resolving three real-world situations. Such situations include using the proposals to bring greater coherence to the determination of the source of interest income. Calderón Gómez quotes language from a prospectus to highlight the uncertainty in sourcing interest income and argues convincingly that his approach would be less manipulable than one focused solely on the payor of the interest. He also demonstrates how his proposals may also help resolve difficult questions regarding whether a disregarded entity should be an obligor.
Calderón Gómez acknowledges that his proposals may at times result in only a “partial victory” if one focuses on revenue raising but argues convincingly that they “would still be a significant improvement from the status quo.” Calderón Gómez is highly persuasive in demonstrating the need for additional attention to this area, and his framework and proposals will serve as a strong foundation for future scholarship.
