Debt issuance costs not deductible after conversion to warrants

Plain-English summary

A company issued convertible debentures and capitalized the related issuance costs. The holder later converted the debt into warrants exercisable for common stock at a nominal price, and the company sought to deduct the remaining unamortized costs. Chief Counsel treated the warrants as stock and concluded that the costs became nondeductible capital expenditures connected with issuing stock. Changes to the cancellation-of-debt rules and related regulations did not make Revenue Ruling 72-348 obsolete or turn the conversion into a cash retirement for all tax purposes.

Ruling snapshot

• Question: May the issuer deduct unamortized debt issuance costs when convertible debt is exchanged for nominal-price stock warrants?
• Outcome: advice given
• Key authorities: IRC §§ 108(e)(8), 162, 263(a); Treas. Reg. §§ 1.61-12(c)(2), 1.263(a)-5, 1.446-5; Rev. Rul. 72-348

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201651014
       Release Date: 12/16/2016
       CC:FIP:B03: ADubert
       PREF-113527-16

UILC: 162.00-00, 446.11-04

date: August 30, 2016

 to:   Associate Area Counsel (South Florida)
       Large Business & International Division

from: Helen Hubbard
Associate Chief Counsel
(Financial Institutions and Products)

subject: --------------------------------, PREF-113527-16
Unamortized Debt Issuance Costs

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.

       LEGEND

       Taxpayer              =       --------------------------------

       Year 1                =       -------
       Year 2                =       -------
       Year 3                =       -------

       Amount 1              =       -------------------
       Amount 2              =       ---------
       Amount 3              =       -----------------
       Amount 4              =       ------------------

       Interest Rate         =       ----------------

PREF-113527-16 2

ISSUE

What is the proper treatment of unamortized debt issuance costs for convertible
debentures upon the conversion of the debentures into warrants exercisable into the
issuer’s common stock?
CONCLUSION

Under Rev. Rul. 72-348, 1972-2 C.B. 97, and the cases cited therein, upon the
conversion of the debentures into stock, the unamortized debt issuance costs assume
the character of a capital expenditure in connection with the issuance of the stock. In
this case, the debentures were converted into warrants, the exercise price of the
warrants is a nominal sum, and the warrants are treated as stock. Accordingly, the
issuer is not entitled to deduct its remaining unamortized debt issuance costs in the
taxable year of the conversion.

FACTS

    In Year 1, Taxpayer issued Amount 1 Interest Rate convertible debentures due in

Year 2 (“Debentures”). At issuance, Taxpayer incurred debt issuance costs, which it
capitalized and amortized on a yearly basis over the term of the Debentures. In Year 3,
per the terms of the Debentures, the holder (“Holder”) exercised its right to convert the
Debentures into Taxpayer’s warrants exercisable into Taxpayer’s common stock
(“Warrants”). The exercise price of the Warrants is a nominal sum, Amount 2 per share.
Taxpayer paid Holder a cash incentive fee of Amount 3. At the time of the conversion,
the unamortized balance of debt issuance costs was approximately Amount 4 (“Costs”),
all of which Taxpayer seeks to deduct in the taxable year of the conversion.

LAW AND ANALYSIS

   Section 162 allows a deduction for all ordinary and necessary expenses paid or

incurred during the taxable year in carrying on any trade or business. However, certain
expenses are required to be capitalized under § 263(a). Under § 1.263(a)-5(a)(9) of the
Income Tax Regulations, debt issuance costs generally are required to be capitalized.
Capitalized debt issuance costs are amortized over the term of a loan. See Enoch v.
Comm’r, 57 T.C. 781 (1972); § 1.446-5, discussed infra; § 162(a).

   Rev. Rul. 72-348, 1972-2 C.B. 97, addresses, inter alia, the tax treatment of

unamortized bond expense when an issuer’s bonds are converted into capital stock of
the issuer. Under the facts of the ruling, the taxpayer incurred costs for commissions
and miscellaneous expenses upon the issuance of convertible debt. The ruling
provides:

  The bond expense was incurred in connection with the issuance of the
  bonds. Upon the conversion of each bond into stock, there was clearly no
  loss suffered by the taxpayer as a result of the transaction. It was purely a
  capital transaction. Its obligation to convert the bonds into stock was

PREF-113527-16 3

   incurred when the bonds, with respect to which the expense in question
   was incurred, were issued. For amortization purposes, the issuance of the
   bonds is not a separate and distinct transaction from the conversion of the
   bond to stock and from the time of conversion any expense incurred in
   connection with the issuance of the original obligations should be treated
   as expense in connection with the issuance of stock of a corporation.

   In support of these conclusions, the ruling cites Liquid Carbonic Corp. v. Comm’r,

34 B.T.A. 1191, 1196 (1936) (“[T]he conversion of bonds into capital stock of the obligor
is purely a capital transaction; that is, a readjustment of the obligor's capital structure,
which does not result in either a deductible loss or a taxable gain.”); Chicago, Rock
Island & Pacific Railway Co. v. Comm’r, 13 B.T.A. 988, 1036 (1928) (“[The issuer]
exchanged its stock for its bonded liability. This was a purely capital transaction, which
did not result in deductible loss or taxable gain.”), aff’d in part, rev’d in part, 47 F.2d 990,
cert. denied, 284 U.S. 618 (1931); Chicago, Milwaukee, St. Paul and Pacific Railroad
Co. v. U.S, 404 F.2d 960, 967 (1968) (holding upon the exchange of the company’s
bonds for the company’s stock in a bankruptcy reorganization, unamortized debt
issuance costs attributable to the issuance of the bonds were no longer deductible).

   Rev. Rul. 72-348 further provides that expenses paid in connection with the

issuance of stock in a corporation are not deductible as ordinary or necessary expenses
of carrying on a business. Rather, such expenses are regarded as capital expenditures.
Rev. Rul. 72-348 (citing Emerson Electric Manufacturing Co. v. Comm’r, 3 B.T.A. 932
(1926), and Simmons Co. v. Comm’r, 8 B.T.A. 631 (1927), aff’d, 33 F.2d 75 (1st Cir.
1929)).

   Based on the authorities above, Rev. Rul. 72-348 concludes:

   [U]pon the conversion of the bonds into stock the unamortized bond
   expense at that date assumes the character of a capital expenditure under
   section 263 of the Code in connection with the issuance of the stock into
   which the bonds were converted and is not deductible by the taxpayer.

   The Warrants afforded Holder the right to purchase Taxpayer’s common stock for

Amount 2 per share, a nominal sum. The nominal purchase price guaranteed that
Holder would exercise the right to acquire the stock under all reasonable scenarios.
Accordingly, Rev. Rul. 72-348 applies to the conversion because the Warrants are
treated as stock. See Rev. Rul. 82-150, 1982-2 C.B. 110.

   Taxpayer argues that it is entitled to deduct the remaining unamortized Costs in

the taxable year in which the conversion took place on the grounds that Rev. Rul. 72-
348 is obsolete following Congress’ enactment of § 108(e)(8). Taxpayer asserts that,
under current law, the retirement of debt for stock is treated the same way as a
retirement for cash.
PREF-113527-16 4

   Section 61(a)(12) provides that gross income includes income from the discharge

of indebtedness (“COD income"). Section 108 provides additional rules for determining
the amount of COD income an issuer must recognize. Section 108(b) requires certain
debtors to reduce certain tax attributes in an amount equal to the excluded amount of
COD income.

   Before 1980, courts had formulated an exception to the inclusion of COD income

or reduction in the debtor’s tax attributes if the debtor exchanged its stock for its
indebtedness ("stock-for-debt exception").1 Beginning with the Bankruptcy Tax Act of
1980, however, the stock-for-debt exception was progressively limited by statute until its
repeal by the Revenue Reconciliation Act of 1993. The Tax Reform Act of 1984, which
added §108(e)(8) (formerly §108(e)(10)(A)), provided a general rule that when stock
was issued for debt, the debtor would be treated as having satisfied the debt with an
amount of money equal to the fair market value of the stock. In other words, as a
general rule, there would be no stock-for-debt exception. However, an exception
(formerly §108(e)(10)(B)) was also added providing for a stock-for-debt exception when
the debtor was insolvent. The Revenue Reconciliation Act of 1993 repealed the stock-
for-debt exception effective generally with respect to stock transferred after 1994 in
satisfaction of any indebtedness.

   Section 108(e), as evidenced by § 108(e)(1) and (e)(8), sets parameters around

the exception set forth in § 108(a) that gross income does not include COD income in
certain circumstances. Taxpayer is generally correct that the repeal of the stock-for-
debt exception results in section 108 treating a debt repurchase, including a conversion,
as a cash retirement equal to the fair market value of the stock. What Taxpayer fails to
acknowledge is that § 108(e)(8) applies only in specified circumstances. The
introductory language to § 108(e)(8) makes clear that the scope of the provision is
limited to “determining income of a debtor corporation from discharge of indebtedness.”2

   Had Congress intended, with the repeal of the stock-for-debt exception, to

overturn Rev. Rul. 72-348 or to cause stock-for-debt exchanges to be treated as cash
retirements for all purposes of the Code, Congress would have said so explicitly in the
statute. See CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69 (1987).

   Taxpayer asserts that, under current law, the retirement of debt for stock is

treated the same way as a retirement for cash. In Taxpayer’s view, the tax treatment of
unamortized debt issuance costs should be the same whether the debt is retired with

1
See e.g., Comm’r v. Motor Mart Trust, 156 F.2d 122 (1st Cir. 1946), acq., 1947-1 C.B. 3; Comm’r v.
Capento Securities Corp., 140 F. 2d 382 (1st Cir. 1944); Alcazar Hotel Inc. v. Comm’r, 1 T.C. 872 (1943).
2
Section 108(e)(8) provides: “For purposes of determining income of a debtor from discharge of
indebtedness, if . . . a debtor corporation transfers stock . . . to a creditor in satisfaction of its recourse or
nonrecourse indebtedness, such corporation . . . shall be treated as having satisfied the indebtedness
with the amount of money equal to the fair market value of the stock . . . [emphasis added].
PREF-113527-16 5

cash or with equity of the issuer. Accordingly, Taxpayer asserts that it should be
entitled to a current deduction for the remaining Costs.

    As support for this position, Taxpayer points to the 1997 amendment to

§ 1.61-12(c)(2)(i), which amended the term “repurchase” to include the conversion of a
debt instrument into stock of the issuer. Section 1.61-12(c)(2) provides, in pertinent
part, that:

  (i) In general. An issuer does not realize gain or loss upon the repurchase
  of a debt instrument. . . . For purposes of paragraph (c)(2), the term
  “repurchase” includes the retirement of a debt instrument, the conversion
  of a debt instrument into stock of the issuer, and the exchange (including
  an exchange under § 1001) of a newly issued debt instrument for an
  existing debt instrument.

  (ii) Repurchase at a discount. An issuer realizes income from the
  discharge of indebtedness upon the repurchase of a debt instrument for
  an amount less than its adjusted issue price (within the meaning of §
  1.1275-1(b)). The amount of discharge of indebtedness income is equal
  to the excess of the adjusted issue price over the repurchase price. See
  section 108 and the regulations thereunder for additional rules relating to
  income from discharge of indebtedness. . . .

  (iii) Repurchase at a premium. An issuer may be entitled to a repurchase
  premium deduction upon the repurchase of a debt instrument for an
  amount greater than its adjusted issue price (within the meaning of
  § 1.1275-1(b)). See § 1.163-7(c) for the treatment of repurchase
  premium.

   Taxpayer is generally correct that an issuer is entitled to a current deduction for

unamortized debt issuance costs upon the retirement of its debt for cash. See
Helvering v. California Oregon Power Co., 75 F.2d 644 (D.C. Cir. 1935); Helvering v.
Central States Electric Corp., 76 F.2d 1011 (2d Cir. 1935) (per curiam); Helvering v.
Union Public Service Co., 75 F.2d 723 (8th Cir. 1935). However, § 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.

   We have found no reason to believe that Rev. Rul. 72-348 has been obsoleted

by revisions to § 108 or by the amendments to § 1.61-12(c)(2)(i).

    Lastly, Taxpayer makes an argument based on § 1.446-5, which was issued in

2003. Section 1.446-5 provides rules for allocating debt issuance costs over the term of
      the debt. In many cases, § 1.446-5 will require the issuer to allocate debt issuance
      costs as if the costs were OID subject to § 1.163-7. Taxpayer infers from this use of the
      rules in § 1.163-7 that any unamortized debt issuance costs at the time of a conversion
      PREF-113527-16 6

should be treated as if they were repurchase premium subject to § 1.163-7(c).
However, § 1.446-5 applies only to debt issuance costs that are “otherwise deductible.”
§ 1.446-5(a).
Both stock issuance costs and debt issuance costs are capital expenditures.
See § 1.263(a)-5(a)(8) and (9). However, debt issuance costs are amortizable whereas
stock issuance costs are not. See Enoch v. Comm’r, 57 T.C. 781 (1972); McCrory
Corp. v. United States, 651 F.2d 828 (2d Cir. 1981); Barbour Coal Co. v. Comm’r, 74
F.2d 163 (10th Cir. 1934); Affiliated Capital Corp. v. Comm’r, 88 T.C. 1157 (1987);
Pacific Coast Biscuit Co. v. Comm’r, 32 B.T.A. 39 (1935), acq. in part, 1935-1 C.B. 15,
non-acq. in part, 1935-1 C.B. 35, withdrawing non-acq.,1954-1 C.B. 6; Van Keuren v.
Comm’r, 28 B.T.A. 480 (1933); Simmons Co. v. Comm’r, 8 B.T.A. 631 (1927), acq.,
1928-2 C.B. 3, aff'd, 33 F.2d 75 (1st Cir. 1929); Appeal of Emerson Electric
Manufacturing Co., 3 B.T.A. 932 (1926). Taxpayer’s argument would create a tax
incentive to issue convertible debt and have a holder immediately convert into its stock
rather than to issue the stock outright, which would be inconsistent with
§ 1.263(a)-5(a)(8).

   Having found that Rev. Rul. 72-348 is still valid, we conclude that the principles

therein are determinative to the facts here. The issuance of Taxpayer’s Debentures
was not a separate and distinct transaction from the conversion of the Debentures into
Warrants in accordance with the terms of the Debentures, and from the time of
conversion, the remaining Costs assume the character of an expense in connection with
the issuance of the Warrants. Accordingly, Taxpayer is not entitled to deduct its
remaining Costs in the taxable year in which the Holder exercised its right under the
conversion feature.

   This writing may contain privileged information. Any unauthorized disclosure of

this writing may undermine our ability to protect the privileged information. If disclosure
is determined to be necessary, please contact this office for our views.

  Please call (202) 317-6945 if you have any further questions.



                               By: _____________________________
                                   Charles W. Culmer
                                   Senior Technician Reviewer, Branch 3
                                   Office of the Associate Chief Counsel
                                   (Financial Institutions & Products)