During the first quarter, the IRS issued PLR 201105030, addressing the repurchase by a corporate taxpayer of its outstanding equity units (“Units”). The Units, which the taxpayer had issued earlier in accordance with the requirements of Revenue Ruling 2003-97, consisted of an undivided beneficial interest in certain notes issued by the taxpayer and a forward contract to purchase the taxpayer’s stock.5 The taxpayer paid, on a quarterly basis to Unit holders, interest on the notes and a fee pursuant to the forward contract. The notes were pledged to secure a Unit holder’s obligations to perform under the stock purchase contract. (See diagram.) After a certain number of years following the issue date and pursuant to the terms of the Units, the taxpayer was required to attempt to remarket the notes to generate proceeds in an amount sufficient to satisfy the Unit holder’s obligation under the stock purchase contract. Following the 4 See PLR 201109017. The revocation of PLR 200440005 was applied without retroactive effect. 5 In Revenue Ruling 2003-97, the IRS ruled that an instrument, such as the Units, should not be treated as a single instrument for federal income tax purposes, but should be treated as consisting of two separate components (i.e., a debt instrument and a forward contract). remarketing and settlement of the stock purchase contract, the notes were intended to remain outstanding for another few years.
Following the issue date of the Units, however, the taxpayer’s financial position had deteriorated, its credit rating had been downgraded significantly and it had experienced a steep drop in its stock price. Considering these circumstances, the taxpayer made an exchange offer to each Unit holder prior to the remarketing date pursuant to which (i) the taxpayer would repurchase the notes in exchange for a number of shares of its common stock plus an amount in cash, and (ii) each Unit holder would pay an amount in cash to the taxpayer for settlement of the stock purchase contract. The fair market value of the common stock plus the amount of cash offered by the taxpayer equaled the adjusted issue price of the notes plus accrued but unpaid interest.
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The IRS provided the following rulings with respect to the exchange offer: (i) the taxpayer’s gain resulting from the cash settlement of the stock purchase contract is not recognized pursuant to Section 1032(a), (ii) because the taxpayer paid each Unit holder an amount equal to the notes’ adjusted issue price plus accrued but unpaid interest, the taxpayer was neither entitled to deduct interest expense (except for accrued but unpaid interest) nor to recognize cancellation of indebtedness income, (iii) no amount paid by the taxpayer pursuant to the exchange offer was deductible, except for the amount paid for the accrued but unpaid interest, (iv) the exchange offer did not prevent the Units from complying with the requirements of Revenue Ruling 2003-97, and (v) the foregoing rulings were not affected by the fact that the payments pursuant to the exchange offer were netted. The taxpayer did have to make a number of representations to obtain these rulings, including that, on the original issue date, it satisfied the requirements of Revenue Ruling 2003-97; that it had not treated the fee payments under the stock purchase contracts as deductible items; that, as of the original issue date of the Units, it did not intend to tender for the notes, or otherwise seek to repurchase the notes with the result that the notes would not be outstanding for at least two years following exercise of the stock purchase contract; that it believed that a remarketing would have a negative impact on its credit rating which could substantially jeopardize its operations; and that, as of the original issue date of the Units, the taxpayer did not reasonably foresee that its financial position and credit rating would deteriorate as it did. Issuers that have instruments such as the Units outstanding with upcoming remarketing dates should keep the facts and circumstances of PLR 201105030 in mind in mapping out their options.