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How disqualified debt interest deduction rule applies when holder is related to issuer

PLR 201517003

In a private letter ruling, IRS has held that the flush language in Code Sec. 163(l)(3), which covers situations in which a debt holder or a related party has the option to convert debt to stock, and not the language in Code Sec. 163(l)(3)(A), which covers situations in which a debt issuer or related party has that option, applies in determining whether the debt is disqualified debt where the debt holder and the debt issuer are related to each other and only the debt holder has the option.

Background. Code Sec. 163(l)(1) provides that no deduction is allowed for any interest paid or accrued on a disqualified debt instrument. Code Sec. 163(l)(2) provides that the term “disqualified instrument” means any indebtedness of a corporation that is payable in equity of the issuer or a related party or equity held by the issuer (or any related party) in any other person. Code Sec. 163(l)(3) prescribes several sets of circumstances in which a debt instrument is treated as payable in equity of the issuer or any other person.

Code Sec. 163(l)(3)(A) provides that a debt instrument is treated as payable in equity of the issuer or any other person if a substantial amount of the principal or interest is required to be paid or converted to, or at the option of the issuer or a related party is payable in or convertible into, such equity.

The flush language that ends Code Sec. 163(l)(3) further provides: “For purposes of this paragraph, principal or interest shall be treated as required to be so paid, converted… if it may be required at the option of the holder or a related party and there is a substantial certainty the option will be exercised.” The legislative history that accompanied the enactment of Code Sec. 163(l)(3), H.R. Rep. No. 105-148 (1997), provided, with respect to the flush language, “For example, it is not expected that the provision will affect debt with a conversion feature where the conversion price is significantly higher than the market price of the stock on the issue date of the debt.”

Facts. Via direct and indirect ownership, Taxpayer corporation was owned 100% by Parent corporation. Taxpayer issued convertible debt which was purchased by Parent. Parent has the option to convert the debt to common stock of Taxpayer. Taxpayer has no option to convert the debt.

IRS says debt is disqualified only if flush language clause is met. IRS ruled that the Code Sec. 163(l)(3) flush language applied to this case and that the Code Sec. 163(l)(3)(A) language did not apply.

It said that Code Sec. 163(l)(3)(A) and the flush language both prescribe conditions that can be satisfied by a convertible debt instrument for which the holder is related to the issuer. On one hand, Code Sec. 163(l)(3)(A) can be satisfied because a substantial amount of the principal or interest on the instrument is convertible into equity of the issuer at the option of a related party (here, the holder). On the other hand, the flush language can be satisfied if a substantial amount of the principal or interest on the instrument is required to be converted into equity of the issuer at the option of the holder, but only if there is a substantial certainty the option will be exercised. Thus, it is not clear whether it is Code Sec. 163(l)(3)(A) or the flush language that should be used to determine whether the instrument is payable in the equity of the issuer.

Congress did not explicitly address the case of a convertible debt instrument for which the issuer and the holder are related. Such an instrument satisfies the condition in Code Sec. 163(l)(3)(A) because of an unaddressed possibility: the related party with the option to convert is the holder. On the other hand, the instrument satisfies the condition in the flush language (without considering, at this point, the “substantial certainty” clause) in the way Congress addressed. This analysis suggests that a determination that the instrument is a disqualified debt instrument under Code Sec. 163(l) should require that there be a substantial certainty the option will be exercised.

In some obvious cases that satisfy the condition in Code Sec. 163(l)(3)(A), the issuer, or a related party different from the holder, has an option to convert the convertible debt instrument into equity of the issuer. In these cases, the issuer, by itself or with the cooperation of the related party, can convert the instrument into its own equity without the consent of the holder. In the current case, the only party with an option to convert the instrument into equity of the issuer is the holder, and the holder indirectly owns 100% of the issuer. IRS said that this difference also suggests that a determination that the instrument is a disqualified debt instrument under Code Sec. 163(l) should require that there be a substantial certainty the option will be exercised.

IRS also said that the above conclusion is confirmed by the legislative history language noted above which provides for no disallowance where the conversion price is significantly higher than the market price of the stock on the issue date of the debt. That language appears to indicate a Congressional preference for treating convertible debt instruments as valid debt in most cases, and the holder is not presumed to receive equity unless it is substantially certain that the holder will in fact receive equity.

Therefore, IRS concluded that the debt was a disqualified debt instrument under Code Sec. 163(l) only if there was a substantial certainty the option would be exercised. IRS did not express an opinion whether the facts in this case indicated that there was such substantial certainty.

References: For the disallowance of a deduction for interest on disallowed debt instruments, see FTC 2d/FIN ¶  K-5507  et seq.; United States Tax Reporter ¶  1634.059; TaxDesk ¶  313,502; TG ¶  18256.

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