A Cautious Approach to Sec. 163(l) in Common Private-Equity Lending

By Brian E. Keller, CPA, Oak Brook, Ill.

Editor: Frank J. O’Connell Jr., CPA, Esq.

Interest Income & Expense

For most practitioners who work in the private-equity arena, complex lending transactions between a private-equity fund and its underlying portfolio investments are everyday occurrences. However, everyday fund financing can carry with it the potential for unintended tax consequences under Sec. 163(l)’s “disqualified debt” rules. Consider the illustration below, which is a basic framework that is common in today’s private-equity lending environment.

Example 1: A private-equity fund, F, is a typical leveraged buyout fund organized as a large, diversely held limited partnership engaged in long-term investing and primarily dedicated to the capital appreciation of its underlying investments. F acquires 80% of the stock of a target corporation, T. The remaining 20% of T’s stock continues to be owned by T’s historic shareholder, who is unrelated to F. In connection with F’s acquisition of T stock, F purchases from T a five-year note bearing a market interest rate and containing the following feature: “At any time and from time to time, at the option of the Holder, any or all amounts then outstanding under this Note may be converted into additional shares of Issuer at a price of $X.” F is the holder of the note (and, hence, the conversion option), and T is the issuer.

Background of Sec. 163(l)

Sec. 163(l)(1) provides that no deduction shall be allowed for interest paid or accrued on a disqualified debt instrument. A disqualified debt instrument is any indebtedness of a corporation that is payable in equity of the issuer or a related party or equity held by the issuer (or any other related party) in any other person. Indebtedness is treated as payable in equity of the issuer or any other person if a “substantial amount of the principal or interest” on the indebtedness:

  1. Is required to be paid in, or converted into, equity; or

  2. At the option of the holder or a related party, is payable in, or convertible into, equity—but only if there is a substantial certainty that the option will be exercised; or

  3. At the option of the issuer or a related party, is payable in, or convertible into, equity (regardless of the likelihood that the issuer will exercise the option).

A person is a related party to the issuer or holder if that person and the issuer or holder, as applicable, bear a relationship described in Sec. 267(b) or Sec. 707(b), which both involve the general application of the more-than-50%-equity-ownership test.


In practice, a requirement that debt be paid in, or converted into, equity is uncommon. Much more common is a conversion feature providing the option that the debt obligation may be paid in, or converted into, equity.

In the example above, instead of F’s purchasing the note from T, assume that the loan to T was made from an unrelated bank. The conversion feature described above is at the option of the note holder (the bank). In this instance, since the bank and T are unrelated, the debt is disqualified only if there is a substantial certainty the option will be exercised.

Whether there is a substantial certainty the option will be exercised is not described in the example, but that situation could arise, for instance, if the conversion feature was “in the money” at issuance. If, in fact, it was, then it appears likely that the option would be treated as substantially certain to be exercised. Because of this substantial certainty that the debt will be converted, it is disqualified debt and, hence, any interest paid or accrued in connection with the debt is not deductible. If the option is out of the money, it is unlikely that the bank will convert the debt. Since it is thus not substantially certain the option will be exercised, the debt is not disqualified, and Sec. 163(l) does not apply to disallow the deduction for interest paid or accrued in connection with the debt.

By contrast, assume that instead of being an option in the hands of F or the unrelated bank as holder, the conversion feature is T’s option as issuer. With that change of fact, the debt is disqualified, regardless of the likelihood the option will be exercised. Although interesting, it is rare in practice to find a conversion option in the hands of the issuer. It is most often structured to be at the holder’s option.

So where does Sec. 163(l) become tricky in everyday private-equity lending? In the example above, F (holder), as the 80% owner of the stock of T (issuer), is related to T. At first reading, one might decide that, since the option is in the hands of the holder, this “substantial certainty” of exercise must exist for the debt to be disqualified. However, when the holder is related to the issuer, the statute, literally applied, takes into account the option held by the “related” holder, regardless of the likelihood that the conversion option will be exercised. Thus, F’s loan to T, in which F holds an option to convert the debt as holder, causes the debt to be disqualified because F is related to T as issuer.

Commentators have suggested that this is an unexpected result, seemingly inconsistent with the legislative implication that an option exercisable solely by the holder should not be taken into account for Sec. 163(l) purposes unless there is a certainty of exercise (see, e.g., Ginsburg, Levin, and Rocap, Mergers, Acquisitions, and Buyouts ¶1306.3 (Aspen 2012)). Although the result appears clear from a literal reading of Sec. 163(l), commentators have suggested that the reference in this provision to “the issuer or a related party” seems designed to address the issuance of debt to an unrelated holder, where the issuer might wish to circumvent Sec. 163’s rule on issuer options by placing the conversion option into the hands of an affiliate of the issuer. Those commentators suggest that these provisions do not seem designed to address the case where a bona fide lender in its capacity as a note holder possesses an option not substantially certain to be exercised and the lender happens to be related to the issuer. Regardless, the statute is unambiguous as literally read.


Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, Ill.

For additional information about these items, contact Mr. O’Connell at 630-574-1619 or frank.oconnell@crowehorwath.com .

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.

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