Forthcoming Guidance on Straddle-Related Debt Instruments Shouldn't Be Retroactive, Writers Argue

[1] We are writing on behalf of an ad hoc coalition of taxpayers who are concerned about the potential effective date of pending regulations addressing the interaction of the constructive sale rules of Section 1259 and the interest capitalization rules of Section 263(g). We are particularly concerned about the possibility that the regulations will include a retroactive expansion of the scope of the capitalization requirement.

[2] Our concern is prompted in large part by the Administration's FY2001 Budget proposal to "clarify" RETROACTIVELY the tax straddle rule relating to the capitalization of interest, even though the "clarification" relates to a statute that has been on the books for 19 years. The Budget proposal would "clarify" that interest is considered properly allocable to a straddle, and must be capitalized under Code section 263(g) if it accrues on a straddle- related debt instrument. The proposal requiring capitalization of interest on straddled-related debt instruments would apply to interest accruals after the date of enactment ("DOE"), and thus would have RETROACTIVE effect on debt instruments issued before the DOE.

[3] THE USE OF A RETROACTIVE EFFECTIVE DATE IN THE PENDING REGULATIONS WOULD AFFECT DEBT INSTRUMENTS USED BY AMERICAN BUSINESSES TO LOWER CAPITAL COSTS. For example, "Participating Hybrid Option Note Exchangeable Securities" (or "PHONES") are exchangeable 30-year debentures, where the investor has the right to convert to the cash value of stock in an unrelated issuer. Because PHONES are exchangeable for the underlying equity -- and hence the payout is contingent -- the debt instrument is subject to the contingent payment rules under the original issue discount ("OID") provisions (and OID is accrued by the issuer and the holder). In the transactions completed to date, the PHONES issuer has held the related stock, but this is not a requirement.

[4] A wide variety of corporations have issued equity-linked debt instruments such as "PHONES" to provide flexibility in meeting capital requirements. While it is clear that PHONES meet all the requirements to be classified as debt under current law, it has been widely reported that the pending regulations would have the effect of denying interest deductions to issuers of these debt instruments. The denial of interest deductions would subject the payments to multiple levels of taxation (once in the hands of the corporation and again when paid to the investor). In turn, multiple taxation would raise financing costs to the issuer.

[5] FOR FEDERAL INCOME TAX PURPOSES, IT IS CLEAR THAT PHONES QUALIFY AS DEBT, THE INTEREST ON WHICH IS DEDUCTIBLE. PHONES are typically issued by well-established companies that are likely to remain in business throughout the term of the obligation. Investors have full creditor rights upon default, and default can force an issuer into bankruptcy or liquidation. Holders have no rights to participate in management. Issuers are not thinly capitalized, and, if interest is deferred, investors must impute interest income (or OID), as is the case with other debt instruments, but not equity. Lastly, the instruments are senior to all preferred equity.

[6] THERE IS NO EVIDENCE THAT THE CAPITALIZATION RULES FOR STRADDLES WERE EVER INTENDED TO APPLY TO INTEREST ON INSTRUMENTS SUCH AS PHONES. The capitalization rule of Code Section 263(g) was aimed at "cash and carry" transactions, where a taxpayer finances the purchase of personal property that is part of a tax straddle. ¹ The statute (in Code section 263(g)(2)(A)) clearly defines the type of expenses subject to the capitalization requirement as "interest on indebtedness INCURRED OR CONTINUED TO PURCHASE OR CARRY the personal property." Significantly, in the 19 years that this rule has been on the books, the Internal Revenue Service has never issued regulations elaborating on the statutory language.

[7] The proceeds of a PHONES issuance are not used to "purchase or carry" a straddle, ² nor is the stock to which the PHONES is linked pledged to repay the debt. Rather, these debt proceeds are used for independent, general corporate purposes. Numerous commentators have written on this topic over the years, and -- almost without exception -- they concluded that 263(g) would not apply to exchangeables (such as DECS, PRIDES, and PHONES). Moreover, we are not aware of any instance in which the Internal Revenue Service has attempted to enforce a position that is contrary to this conclusion.

[8] A retroactive application of Section 263(g) would have a negative impact on economic transactions conducted over the past several years by affecting the economics of existing instruments such as PHONES, because issuers relied on the accepted interpretation of current law that Section 263(g) would not apply. Moreover, these instruments might have been issued in alternative forms -- or not at all -- had the Internal Revenue Service adopted a contrary interpretation. For these and the other reasons noted above, we would urge you to refrain from promulgating regulations to apply Section 263(g) to PHONES on a retroactive basis.

[9] We would be pleased to discuss these comments further with you or your staff at your earliest convenience.

Respectfully submitted,

² See Rev. Proc. 72-18, 1972-1 C.B. 740 (where the IRS gave a narrow interpretation to the term "purchase or carry" in the context of Code section 265, indicating that in the absence of direct evidence (viz., where the proceeds of indebtedness are used for, and are directly traceable to, the purchase or carrying, or the purchased security is used as collateral for the indebtedness), section 265(2) of the Code will apply only if the totality of facts and circumstances supports a reasonable inference that the purpose to purchase or carry tax-exempt obligations exists.).