In a recent Chief Counsel Advice memorandum,17 the IRS concluded that equity-linked debt instruments issued by the Taxpayer, which referenced the value of shares of an underlying company, X, held by the Taxpayer, constituted a “position” under Section 1092(d)(2) and thus, qualified as part of a straddle for federal tax purposes. Accordingly, the IRS held that the Taxpayer must capitalize interest expense related to the debt instrument pursuant to Section 263(g)(1), and the basis of new shares of the underlying company received in a non-taxable exchange must include the related repurchase premium and interest capitalized into the basis of shares so transferred. Although the CCA is redacted, the instument described in the CCA has many of the same features as a PHONES transaction.21
The debt instruments issued were publicly traded and were exchangeable for X stock held by the Taxpayer, which was previously acquired in an unrelated transaction. The debt instruments were publicly traded and were treated as contingent payment debt instruments for federal income tax purposes. The debt instruments issued by the Taxpayer replaced similar debt of the Taxpayer, which were retired with the new debt issuance.
The debt instruments contained a put right by the holder for a fixed number of shares of X stock subject to adjustment for certain events such as a merger or stock split, or at the Taxpayer’s option, the equivalent amount of cash. Pursuant to the terms of the debt instrument, Taxpayer was required to maintain a deposit of shares of X stock with an exchange agent sufficient to meet the exchange obligation. Taxpayer retained the right to dividends and to vote the X stock; however, Taxpayer could not otherwise use the X stock, including pledging it for another debt or hypothecating it.
Before the stated maturity date of the debt instruments, the holders exercised their put right to exchange the debt instruments for shares of X stock. The Taxpayer chose to pay the cash equivalent amount to the holders. At all times during the redemption period, the average stock price exceeded the exercise price of the debt instrument. Taxpayer deducted the repurchase premium as interest. At a later time and in an unrelated transaction, Taxpayer exchanged the X stock for stock of a new corporation spun-off by X in a tax-free reorganization.
A straddle is defined in Section 1092(c)(1) as consisting of “offsetting positions with respect to personal property.” A position is considered to be offsetting if there is substantial diminution of the taxpayer’s risk of loss from holding one position by reason of holding the other position. Personal property is defined in Section 1092(d)(1) as “any personal property of a type which is actively traded,” and a position is defined in Section 1092(d)(2) to include “an interest (including a futures or forward contract or option) in personal property.”
The IRS concluded that the debt instruments and shares of X stock were offsetting positions under Section 1092 because the Taxpayer’s risk of loss from the debt instrument was substantially diminished by its holding of the X stock. Implicit in the IRS’ determination is that in certain instances, a debt instrument can represent a “position” since the debt instrument at issue was exchangeable at the holder’s option for an amount that referenced the value of X stock, and thus economically was equivalent to a short position in the stock. The IRS ignored the fact, however, that the issuer could not force an exchange.
The IRS then determined that the X stock was a position with respect to substantially similar or related property to the debt instruments under Treas. Reg. Sec. 1.246- 5(b)(1) since (i) the fair market value of the X stock and the debt instruments taking into account exchange rate on the X stock primarily reflected the performance of X corporation and (ii) changes in the fair market value of the stock are reasonably expected to approximate changes in value of the debt instruments. As a result, the IRS held that the stock was personal property for purposes of the straddle rules and the Taxpayer’s position in the debt instruments coupled with its holdings of X stock constituted a straddle.
The next issue the IRS addressed was whether the Taxpayer’s payment of a repurchase premium and coupon interest with respect to the debt instruments constituted interest or carrying charges “incurred or continued to purchase or carry” the X stock under Section 263(g). The repurchase premium paid by the Taxpayer resulted from the fact that the amount paid to repurchase the debt instruments, which included settlement of the holder’s put right for X stock, was greater than the adjusted issue price of the debt instrument. Treas. Reg. Sec. 1.163-7 provides that where an issuer repurchases its own debt instrument at a price which exceeds the adjusted issue price, such excess amount is deductible as interest in the tax year the repurchase occurs. The IRS, therefore, concluded that the repurchase premium was treated as “interest on indebtedness” for purposes of Section 263(g).
The IRS then considered whether the repurchase premium and interest coupon qualified as interest which was “incurred or continued to purchase or carry personal property that is part of a straddle.” The IRS concluded based on a facts and circumstances determination that a clear, direct relationship existed between the debt instruments and the X stock, specifically that the Taxpayer’s purpose for incurring the debt instrument was to carry the X stock. Specifically, the IRS looked to various agreements the Taxpayer entered into following the issuance of the debt instruments, including Taxpayer’s deposit of the X shares with the exchange agent. The IRS also took into account the fact that holders benefited from the right to share in the appreciation of X stock in exchange for the receipt of interest payments which were below the stated market rate, or the relevant comparable yield which the Taxpayer used to accrue interest income pursuant to the CPDI rules.
Lastly, the IRS held that the Taxpayer’s basis in new shares it received in exchange for its X stock pursuant to a tax-free reorganization would include any repurchase premium and interest coupons previously capitalized into Taxpayer’s holdings of X stock.
Of course, it goes without saying that the CCA is private IRS guidance that cannot be relied on and that does not represent an official position of the IRS. Moreover, a key tax benefit of PHONES was eliminated by the expansion of Section 163(l) in the American Jobs Creation Act of 2004.