Debt issuance costs are capital expenditures, IRS concludes

Tax Hot Topics: Debt issuance costs are capital expenditures, IRS concludesThe IRS concluded in a recently released internal legal memorandum (ILM 201651014) that a taxpayer could not deduct the unamortized debt issuance costs related to its convertible debt when the convertible debt was converted into stock.

Under the facts of the memorandum, a corporate taxpayer incurred debt issuance costs when it issued convertible debentures. The taxpayer capitalized and amortized the debt issuance costs over the term of the debentures. The debentures provided the holder the right to convert the debentures into warrants to acquire the taxpayer’s common stock. Because the exercise price of these warrants was nominal, the warrants were regarded as taxpayer stock under Rev. Rul. 82-150.

In a subsequent year, the holder of the debentures exercised its right to convert the debentures into the warrants. The memorandum focused on whether the taxpayer could deduct the unamortized balance of debt issuance costs related to the debentures.

An issuer of a debt instrument is generally entitled to deduct the amount of unamortized debt issuance costs upon the retirement of the underlying debt for cash under Helverling v. California Oregon Power Co., 75 F. 2d 644 (D.C. Cir. 1935). However, Rev. Rul. 72-248 provides that the unamortized debt issuance costs related to convertible bonds were not deductible when the bonds converted into the issuer’s stock.  

The IRS concluded that the taxpayer could not deduct the unamortized debt issuance costs related to the debentures under Rev. Rul. 72-248.

The taxpayer had argued that Rev. Rul. 72-348 was obsolete because of more recent legislative developments. Specifically, prior to 1993, a corporation did not have to include income from the cancellation of debt if it issued its own stock in retirement of a debt under certain circumstances (the stock-for-debt exception). However, the stock-for-debt exception was repealed in 1993. Thus, the taxpayer argued that the repeal of the stock-for-debt exception made Rev. Rul. 72-248 obsolete. Currently, Section 108(e)(8) provides that a corporation will incur cancellation of debt income when it issues stock to retire its debt and the adjusted issue price of the debt exceeds the fair market value of stock.

In the memorandum the IRS disagreed with the taxpayer’s position that Rev. Rul. 72-248 was obsolete. The IRS stated, “[H]ad Congress intended, with the repeal of the stock-for-debt exception, to overturn Rev. Rul. 72-248 or to cause stock-for-debt exchanges to be treated as cash retirements for all purposes of the Code, Congress would have said so explicitly in the statute.”

Contact Andy Cordonnier
Partner, Washington National Tax Office
+1 202 521 1502

Jeff Borghino
Partner, Washington National Tax Office
+1 202 521 1532

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