IRS concludes transaction may lack economic substance

In a chief counsel advice memorandum (CCA 201515020) released April 10, the IRS concluded that it may disregard a taxpayer's participation in a transaction under the common law economic substance doctrine (ESD).

Under the facts of the CCA, a taxpayer entered into a transaction with a broker that consisted of two legs: (i) a loan and (ii) a prepaid forward contract.

The loan was made by the broker, as a lender, to the taxpayer as the borrower. The loan had a stated principal amount and provided for 64 quarterly installments of interest and principal over a 20-year period. The proceeds of the loan were used by the taxpayer to purchase a prepaid forward contract from the broker.

The contract obligated the broker to deliver a certain amount of bonds or their cash equivalent to the taxpayer and required the broker to make payments corresponding with the payment schedule of the loan over a 20-year period. The loan and the contract were designed to create offsetting rights and obligations over the same 20-year period.

Both the loan and the contract were marketed to the taxpayer by a promoter as a way to currently deduct interest expense on the loan and recognize long-term capital gain on the contract.

Applicable case law related to the ESD analyzes two factors in determining whether a transaction lacks economic substance: (i) whether the transaction changes the taxpayer's objective economic position apart from tax benefits and (ii) whether the taxpayer has a subjective nontax purpose for entering into the transaction. The IRS concluded that it may disregard the taxpayer's participation in the loan and the contract because the participation would fail either prong of the ESD.

IRS rules on applicability of Section 163(l) to a convertible note

The IRS ruled in a private letter ruling(PLR 201517003) released April 24 that a convertible debt held by a person related to the issuer was subject to Section 163(l) if there was a substantial certainty that the conversion option would be exercised.

Under the facts of the PLR, a parent corporation owned 100% of another corporation (Company 1), which in turn owned 100% of another corporation (the taxpayer). The taxpayer owed convertible debt to the parent.

The note provided for a stated principal amount equal to an amount advanced by the parent to the taxpayer, and a stated interest rate that was set at a market rate on the issue date of the note. On the maturity date of the note, the taxpayer was required to pay the parent corporation the stated principal amount plus all stated interest, known as the redemption amount. The terms of the convertible note also provided that the parent could convert some or all of the redemption amount into the taxpayer's common stock. If the parent didn't convert under this conversion feature, the taxpayer would pay the redemption amount in cash at maturity.

The taxpayer represented that the parent would exercise the conversion feature related to the note only if the value of the stock to be received exceeded the redemption amount.

Section 163(l)(1) disallows a deduction for any interest (or original issue discount) paid or accrued on a "disqualified debt instrument." A disqualified debt instrument includes any debt of a corporation that is payable in equity of the issuer or a related party.

For purposes of Section 163(l), a person is related to another person if such person bears a relationship described in Section 267(b).

Section 163(l)(3) provides that debt is treated as "payable in equity" if one of the three following conditions is met:

(i) A substantial amount of the principal or a substantial amount of the interest is required to be paid or converted, or at the option of the issuer or a related party, is payable or convertible into such equity (Category A).

(ii) A substantial amount of the principal or a substantial amount of the interest is required to be determined, or at the option of the issuer or a related party, is determined, by reference to the value of such equity (Category B).

(iii) The indebtedness is "part of an arrangement" that is reasonably expected to result in a transaction described in Sections 163(l)(3)(A) or (B) (Category C).

Section 163(l)(3) further provides that principal or interest is required to be payable in equity under Categories (A), (B) or (C) if (i) they may be required at the option of the holder or a related party and (ii) there is substantial certainty that such option will be exercised.

Because the parent was related to the taxpayer, the convertible note would appear to constitute a disqualified debt instrument in Category A. However, the IRS ruled that the convertible note constituted disqualified debt only if there was a substantial certainty that the conversion feature would be exercised.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.