In CCA 201651014, the IRS, relying on Revenue Ruling 72-348, concluded that a taxpayer may not deduct remaining unamortized debt-issuance costs related to convertible debt that is physically converted into stock. In so ruling, the IRS dismissed the assertion that Revenue Ruling 72-348 has been obsoleted by interim changes to the Internal Revenue Code and regulations.

Facts

Taxpayer issued convertible debentures for which it incurred debt-issuance costs. Taxpayer capitalized and amortized the costs over the term of the debentures. By their terms, the debentures were convertible into Taxpayer's warrants (which were in turn exercisable for Taxpayer's common stock for a nominal exercise price). Before maturity, Taxpayer paid a cash fee to induce a debt holder to exercise the conversion feature. Taxpayer asserted that the unamortized balance of debt-issuance costs is deductible in the tax year of the conversion of the debentures into warrants.

Analysis

Section 162 allows a deduction for all ordinary and necessary business expenses, but certain costs must be capitalized under Section 263(a). Under Reg. § 1.263(a)-5(a)(9), costs incurred to facilitate a borrowing (debt-issuance costs) must be capitalized. These costs are amortizable over the term of the debt under Reg. § 1.446-5.

Revenue Ruling 72-348 addresses the treatment of both unamortized discount and unamortized bond expense when an issuer's bonds are converted into capital stock of the issuer. Based on a number of cases cited in the ruling, the ruling concludes that a taxpayer cannot deduct either unamortized discount or unamortized bond expense upon the physical conversion of convertible bonds into stock because the exchange of bonds into stock is a capital transaction.

Thus, the revenue ruling concludes that, upon the conversion of the bonds into stock, the unamortized discount is not deductible, and the unamortized bond expense becomes a capital expenditure under Section 263 and also is not deductible by the taxpayer.

Although Revenue Ruling 72-348 by its terms does not apply to Taxpayer's situation because the debt was converted into warrants rather than stock, the IRS asserts that the nominal exercise price of the warrants guaranteed that the holder would exercise the right to acquire the stock under all reasonable scenarios. Consequently, according to the IRS, the warrants should be treated as stock and Revenue Ruling 72-348 applies to the conversion.

The IRS dismissed Taxpayer's argument that the revenue ruling is obsolete because of the enactment of Section 108(e)(8). Section 108(e)(8) repealed the "stock-for-debt" exception to the recognition of cancellation of debt income and generally caused stock-for-debt exchanges to be taxable to the issuer. While agreeing with Taxpayer that Section 108(e)(8) treats a debt repurchase for stock, including a conversion, as a cash retirement equal to the fair market value of the stock, the IRS concluded the application of Section 108(e)(8) is limited by its introductory language. Specifically, Section 108(e)(8) states that it is limited to "determining income of a debtor corporation from discharge of indebtedness." Since Revenue Ruling 72-348 was not explicitly overruled upon enactment of Section 108(e)(8), the IRS reasoned, it should be assumed that the revenue ruling continues to apply.

The IRS similarly rejected Taxpayer's attempt to use Reg. § 1.61-12(c)(2) in support of its argument that the costs are deductible because the retirement of debt for stock is treated the same as a retirement for cash. Again, the IRS agreed generally with Taxpayer, but asserted that Reg. § 1.61-12(c)(2) does not equate a stock-for-debt exchange to a cash retirement of debt for all purposes of the Code, citing Revenue Ruling 72-348.

Finally, the IRS disagreed with Taxpayer's argument that Reg. § 1.446-5 permits the deduction. Reg. § 1.446-5 generally requires an issuer to determine the timing of the deduction for debt-issuance costs as if the costs were original issue discount (OID) subject to Reg. § 1.163-7. According to the IRS, Taxpayer inferred from the cross reference to the rules in Reg. § 1.163-7 that any unamortized debt-issuance costs at the time of a conversion should be treated as if they were a repurchase premium (i.e., unamortized OID) subject to Reg. § 1.163-7(c). The IRS rejected this argument because of the statement in Reg. § 1.446-5(a) that the rule applies only to debt-issuance costs that are "otherwise deductible."

Both stock-issuance costs and debt-issuance costs are capital expenditures under Reg. § 1.263(a)-5(a)(8) and (9). The IRS cited a number of court cases in support of its view that debt-issuance costs are amortizable while stock-issuance costs are not. The IRS asserted that Taxpayer's argument would create a tax incentive to issue convertible debt and have a holder immediately convert into the issuer's stock rather than to issue the stock outright, which would allow the issuer to deduct the costs in a manner inconsistent with Reg. § 1.263(a)-5(a)(8). This last argument seems somewhat implausible, given the potential corporate and securities laws implications of such a transaction and the ability of the IRS to assert other doctrines or principles to disallow the deduction in such a case.

Having rejected all of Taxpayer's arguments, and relying on the holding of Revenue Ruling 72-348, the IRS concluded that Taxpayer was not entitled to a deduction for its remaining unamortized debt-issuance costs in the tax year in which the holder exercised its conversion right.

Implications

In this CCA, the IRS has taken a very narrow view of the consequences of the enactment of Section 108(e)(8) and promulgation of Reg. §§ 1.61-12(c)(2) and 1.163-7(c) in order to maintain a position that Revenue Ruling 72-348 continues to disallow a deduction for unamortized debt-issuance costs upon the physical conversion of debt. In fact, the CCA does not seem to acknowledge that one of the two holdings in Revenue Ruling 72-348 (the holding regarding the deduction for unamortized discount) is clearly implicated by the statutory and regulatory changes described previously. Many practitioners view Revenue Ruling 72-348 as no longer being good law because the thrust of the holdings of the authorities (and the analysis therein) relied upon by the ruling have been overturned by statutory and regulatory changes. Nevertheless, the CCA effectively announces that the IRS intends to continue to apply this ruling, at least for unamortized debt-issuance costs.

Moreover, although the CCA and the underlying Revenue Ruling 72-348 address only the consequences upon the physical conversion of convertible debt, some of the authorities on which the rulings relied apply to any satisfaction of debt with stock. Accordingly, the analysis in the CCA could also extend to a negotiated settlement of nonconvertible debt with stock. We hope that the IRS does not intend to extend its argument that far.

Finally, this CCA (and the revenue ruling) by its terms does not apply to cash-settled conversions, which have never been tax-free to the issuer. Although there has been no explicit guidance on this point, practitioners take the view that unamortized debt-issuance costs upon a cash-settled conversion are deductible. For net share settled conversions, which are quite common, even if the IRS's conclusion in the CCA is correct, the issuer should be able to deduct at least a proportionate amount of the unamortized debt-issuance costs, and perhaps the entire remaining amount of costs, provided the full amount of the debt principal is paid in cash.

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