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The IRS concluded in a recently released field attorney advice memorandum (FAA 20151201F) that certain debt instruments issued by a taxpayer constituted an offsetting position in a “straddle” as defined in Section 1092(c)(1).
In the FAA, a taxpayer issued exchangeable senior debentures that provided for quarterly coupon payments and a fixed maturity date. At maturity, the holders of the debentures were entitled to receive cash. However, a specified amount of the principal was exchangeable for a basket of shares in specific public companies (reference shares). At the time the debentures were issued, the taxpayer owned a specified amount of reference shares.
The holders of the debentures would receive the value of cash dividends paid related to the reference shares and the cash value of any in-kind distributions. The principal amount of the debentures was not reduced by any amounts paid related to regular cash dividends but would be reduced for extraordinary dividends. In no event would the principal amount be reduced below zero.
The holders could at any time exchange the debentures for either (i) the reference shares or (ii) at the taxpayer’s option, the cash equivalent.
The taxpayer could redeem the debentures for cash on certain dates if certain conditions occurred. The holders could exchange the debentures if they were called for redemption, which effectively required the taxpayer to pay the greater of (i) the value of the reference shares related to redeemed debentures or (ii) the sum of the outstanding principal, and the accrued and unpaid interest related to the redeemed debentures.
The holders could tender the debentures on a specified date for their principal amount and the accrued and unpaid interest, but the issuer could elect to pay that amount in cash, reference shares, or a combination of both.
The taxpayer characterized the debentures as “contingent payment debt instruments” under Treas. Reg. Sec. 1.1275-4. Section 263(g)(1) disallows a deduction for interest and carrying charges that can be properly allocated to personal property, which is part of a straddle.
A straddle is defined in Section 1092(c)(1) as “offsetting positions with respect to personal property.” Positions are considered offsetting if there is a substantial diminution of the taxpayer’s risk of loss from holding one position by reason of holding the other position under Section 1092(c)(2)(A).
Section 1092(d)(1) defines “personal property” as any personal property that is actively traded. A “position” is defined in Section 1092(d)(2) as an interest in personal property including a futures contract, a forward contract or an option.
From the obligor’s perspective, a debt is generally not regarded as personal property; however, a debt may represent a position in personal property under certain circumstances. For example, an obligor’s debt instrument is a position related to personal property and may be part of a straddle if one or more payments are linked to the value of personal property or a position with related to personal property. See Treas. Reg. Sec. 1.1092-1T(d).
The IRS concluded in FAA 20151201F that the taxpayer created a straddle by issuing the debentures and holding the reference shares, and that the taxpayer was required to capitalize the interest that could be attributed to the debentures.
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