Sec. 163(I)’s “Substantial Certainty” Test and Related-Party Convertible Debt

By Jeff Borghino, CPA,Washington

Editor: Greg A. Fairbanks, J.D., LL.M.

The IRS concluded in Letter Ruling 201517003 that a convertible debt held by a person related to the issuer was subject to Sec. 163(l) only if there was a substantial certainty that the conversion option would be exercised. The letter ruling is noteworthy because it had conflicting facts in determining whether Sec. 163(l) applied. This item summarizes the current law and discusses the facts and conclusion in Letter Ruling 201517003.

Sec. 163(l)

Congress originally enacted Sec. 163(l) in 1997 because it was concerned that corporations could issue debt that more closely resembled equity, for which an interest deduction was not appropriate (Staff of Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997, at 193 (the 1997 Bluebook)).

Under Sec. 163(l)(1), no deduction is allowed for interest paid or accrued on a disqualified debt instrument. However, Sec. 163(l) does not affect the characterization of a disqualified debt instrument as debt or equity or the treatment of its holder (the 1997 Bluebook).

A disqualified debt instrument means any debt of a corporation that is "payable in equity," which refers to either: (1) equity of the issuer or a party related to the issuer; or (2) equity held by the issuer or a party related to the issuer. For purposes of Sec. 163(l), a person is related to another person if the person bears a relationship described in Sec. 267(b) or 707(b).

Sec. 163(l)(3) provides that debt is treated as "payable in equity" if a substantial amount of the principal or interest is:

1. Required to be paid in, converted into, or determined by reference to the value of the equity;

2. Payable in, convertible into, or determined by reference to the value of the equity at the option of the issuer; or

3. Payable in, convertible into, or determined by reference to the value of the equity at the option of a related party to the issuer (the related-party option test).

Under Sec. 163(l)(3)(C), a debt is treated as payable in equity if it is part of an arrangement that is reasonably expected to result in one of these circumstances.

In addition, the statute provides that a debt is treated as payable in equity if: (1) a substantial amount of the principal or interest may be required at the option of the holder, or a related party to the holder, to be paid in, converted into, or determined by reference to the value of the equity; and (2) there is a substantial certainty that the option will be exercised (the holder option test).

The Code and regulations currently do not provide a definition for a substantial certainty in this context, but the legislative history states "it is not expected that [Sec. 163(l)] will affect debt with a conversion feature where the conversion price is significantly higher than the market price of the stock on the issue date of the debt" (H.R. Rep't No. 105-220, at 524 (1997) (the 1997 House Report)).

Letter Ruling 201517003

In Letter Ruling 201517003, a corporation (Parent) owned 100% of another corporation (Company 1). Both Parent and Company 1 were incorporated in the same country. Company 1 owned 100% of a U.S. corporation (Taxpayer). Parent and Taxpayer were related under Sec. 267(b).

Taxpayer intended to issue a convertible debt instrument (the convertible note) to Parent in exchange for money. The convertible note was denominated in the currency of the country where Parent was incorporated, with a stated principal amount equal to the amount advanced by Parent. The convertible note provided for interest set at a market rate on the issue date that exceeded the applicable federal rate. The stated interest accrued monthly but was not required to be paid until maturity. Because the stated interest was not required to be paid currently, the stated interest constituted original issue discount as defined in Sec. 1273 and was not deductible under Sec. 163(e)(3) until paid by Taxpayer.

On the repayment date, Taxpayer was required to pay the sum of the stated principal amount and all accrued stated interest (the redemption amount). Taxpayer was required to pay the redemption amount in cash unless the convertible note was converted into shares of Taxpayer's stock. Taxpayer had to obtain Parent's consent if it wished to satisfy the convertible note earlier than maturity, and Parent could not put the convertible note to Taxpayer prior to maturity unless there was a default event or a change of control of Taxpayer's ownership.

The terms of the convertible note permitted Parent to convert some or all of the redemption amount into Taxpayer common stock (the conversion feature). Under the conversion feature, the maximum amount of shares that Parent could receive was determined by the ratio of (1) the redemption amount over (2) the product of the initial fair market value and a specified factor. Taxpayer proposed the specified factor be greater than 1.

The number of shares that Parent was eligible to receive under the conversion feature could be adjusted if certain organizational actions occurred, if third parties subscribed to capital infusions to Taxpayer for less than the market price, and if Taxpayer distributed a dividend in excess of a specified percentage of distributable profits.

Taxpayer represented that Parent would exercise the conversion feature only if the value of the stock to be received exceeded the redemption amount.

The primary issue in Letter Ruling 201517003 was whether the convertible note constituted a disqualified debt instrument; however, it was unclear how the statute should be applied in the fact pattern. From one perspective, the convertible note could qualify as a disqualified debt instrument under the related-party option test. Because the conversion feature was an option of Parent to convert the convertible note into Taxpayer common shares, and Parent and Taxpayer were related under Sec. 267(b), the related-party option test could apply, and the convertible note would constitute a disqualified debt instrument based on a plain reading of the statute.

Alternatively, the convertible note could qualify as a disqualified debt instrument under the holder option test because the conversion feature was an option of Parent in Parent's capacity as the holder of the convertible note. Thus, the convertible note would constitute a disqualified debt instrument only if there was a substantial certainty that the conversion feature would be exercised.

The IRS ruled in Letter Ruling 201517003 that the convertible note was a disqualified debt instrument only if there was a substantial certainty that the conversion feature would be exercised under the holder option test.

In its analysis, the IRS recognized that Congress did not explicitly address the circumstance of a convertible debt instrument in which the issuer and the holder are related. Furthermore, the IRS distinguished the application of the related-party option test "because of an unaddressed possibility," while the holder option test would apply "in the way Congress addressed."

In addition, the IRS noted that an "obvious" case that satisfies the related-party option test is a situation in which a related party that was not the holder had an option to convert a debt into equity without the holder's consent. In comparison, the only party with the option under the conversion feature was the holder in Letter Ruling 201517003.

Finally, the IRS cited the 1997 House Report, which stated Sec. 163(l) was not expected to affect debt with a conversion feature where the conversion price is significantly higher than the market price of the stock on the debt's issue date. The IRS stated that the flush language of the 1997 House Report "indicates that a convertible debt instrument should be treated as payable in equity when there is a substantial certainty that the holder will end up with equity."

Commentary

Notwithstanding the IRS's ruling in Letter Ruling 201517003, there remains uncertainty in applying either the related-party option test or the holder option test under facts similar to those in this letter ruling.

First, the IRS's conclusion in Letter Ruling 201517003 may be different for taxpayers with similar but distinguishable facts. For example, suppose the holder of the convertible debt directly wholly owned the issuer's stock and the exercise of the holder's option was a "meaningless gesture" (see James Armour, Inc., 43 T.C. 295 (1964) and similar authorities). The IRS may have reserved a different view for this fact pattern when it stated in Letter Ruling 201517003:

We express no opinion about whether the conversion feature is "payable in equity," as described in section 163(l)(2), when the party that can exercise the conversion feature already owns, directly or indirectly, 100% of the issuer.

Second, there is still no guidance regarding when there is a substantial certainty that an option will be exercised under the holder option test. Similarly, there is no guidance to determine when a conversion price is significantly higher than the market price of the stock as referred to in the 1997 House Report. Of relevance in Letter Ruling 201517003, the conversion feature might have been "out of the money" because the specified factor was proposed to be greater than 1. However, whether the conversion price was significantly higher than the stock's market price did not directly affect the ruling that the holder option test was appropriately applied in lieu of the related-party option test.

Finally, the ruling was directed only to the requesting taxpayer and may not be used or cited as precedent under Sec. 6110(k)(3). While a private letter ruling may be an authority considered to determine whether there is substantial authority for the tax treatment of an item (see Regs. Sec. 1.6662-4(d)(3)(iii)), taxpayers may need to consider applying for their own private letter ruling absent more definitive guidance from the IRS.

Furthermore, under a plain reading of the statute, the related-party option test clearly applied to the facts in Letter Ruling 201517003. Because the application of the related-party option test to these facts does not appear to create an egregious tax result, it is quite challenging for tax advisers to reach a conclusion that meets the more-likely-than-not standard without any precedential authority. Accordingly, taxpayers would be well-advised to request a private letter ruling under these circumstances.

EditorNotes

Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

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