IRS rules on applicability of Section 163(l) to a convertible note

Tax Hot Topics - IRS rules on section 163lThe IRS ruled in a private letter ruling (PLR 201517003) released April 24 that a convertible debt held by a person related to the issuer was subject to Section 163(l) if there was a substantial certainty that the conversion option would be exercised.

Under the facts of the PLR, a parent corporation owned 100% of another corporation (Company 1), which in turn owned 100% of another corporation (the taxpayer). The taxpayer owed convertible debt to the parent.

The note provided for a stated principal amount equal to an amount advanced by the parent to the taxpayer, and a stated interest rate that was set at a market rate on the issue date of the note. On the maturity date of the note, the taxpayer was required to pay the parent corporation the stated principal amount plus all stated interest, known as the redemption amount. The terms of the convertible note also provided that the parent could convert some or all of the redemption amount into the taxpayer’s common stock. If the parent didn’t convert under this conversion feature, the taxpayer would pay the redemption amount in cash at maturity.

The taxpayer represented that the parent would exercise the conversion feature related to the note only if the value of the stock to be received exceeded the redemption amount.

Section 163(l)(1) disallows a deduction for any interest (or original issue discount) paid or accrued on a “disqualified debt instrument.” A disqualified debt instrument includes any debt of a corporation that is payable in equity of the issuer or a related party.

For purposes of Section 163(l), a person is related to another person if such person bears a relationship described in Section 267(b).

Section 163(l)(3) provides that debt is treated as “payable in equity” if one of the three following conditions is met:

    (i)   A substantial amount of the principal or a substantial amount of the interest is required to be paid or converted, or at the option of the issuer or a related party, is payable or convertible into such equity (Category A).

    (ii)   A substantial amount of the principal or a substantial amount of the interest is required to be determined, or at the option of the issuer or a related party, is determined, by reference to the value of such equity (Category B).

    (iii)   The indebtedness is “part of an arrangement” that is reasonably expected to result in a transaction described in Sections 163(l)(3)(A) or (B) (Category C).

Section 163(l)(3) further provides that principal or interest is required to be payable in equity under Categories (A), (B) or (C) if (i) they may be required at the option of the holder or a related party and (ii) there is substantial certainty that such option will be exercised.

Because the parent was related to the taxpayer, the convertible note would appear to constitute a disqualified debt instrument in Category A. However, the IRS ruled that the convertible note constituted disqualified debt only if there was a substantial certainty that the conversion feature would be exercised.

Andy Cordonnier
+1 202 521 1502

Jeff Borghino
+1 202 521 1532

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