The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 7, February 1999, Panel Publishers, New York, NY.
REDEMPTION EXPENSES NONDEDUCTIBLE: AVOIDING REDEMPTION CHARACTERIZATION
By Robert W. Wood, San Francisco
It is well-known that Section 162(k) of the Code restricts the deductibility of expenses paid or incurred in connection with a stock redemption. Basically, Section 162(k) disallows any amount paid or incurred by a corporation in connection with the redemption of its stock. The only exceptions to this general no-deduction rule are for deductions allowable under Section 163 (relating to interest) or deductions for dividends paid (within the meaning of Section 561). There are special rules that relate to redemptions of stock in certain regulated investment companies. However, in general Section 162(k) provides a fairly tight net on redemption expenses.
Recent FSA
In a recently released Field Service Advice (1998-410), the IRS has advised on the deductibility of various expenses incurred in connection with a redemption. This FSA notes that a variety of types of expenses can be considered. It is an instructive Field Service Advice, since many of these types of expenses are incurred in a typical redemption by a corporation of its own stock:
Loan fees incurred before the effective date of Section 162(k) are
amortizable over the life of the loan; however, other fees connected with
the redemption are nondeductible, nonamortizable capital costs.
A claimed late closing fee was really an additional payment for
the redeemed stock, and hence nondeductible.
Interest incurred in paying off notes converted from preferred stock
was considered deductible, because the notes were bona fide debt and interest
was not a dividend on the preferred stock.
Loan fees incurred in borrowing to pay off notes were considered
deductible under the appropriate amortization schedule because they were
too remote from the redemption.
Payments to employees for cancellation of their stock options were
deductible.
Debt prepayment penalties were not considered to be paid or incurred in connection with the redemption, and were therefore deductible in the year of the payment.
Scope of Restrictions
The types of transactions that are considered redemptions and hence subject to the Section 162(k) nondeductibility gauntlet may seem rather narrow. By its terms, Section 162(k) only applies to stock redemptions by a corporation of its own stock. However, other authorities suggest that the reach of Section 162(k) can be broader than this.
For example, in another 1993 Field Service Advice (recently released in 1998 as FSA 1998-419), the IRS advised that an acquiring corporation's purchase of a target corporation's stock followed by its merger into a target corporation should be treated for tax purposes as a redemption of the target corporation's stock.
Under the merger agreement, the acquiring corporation offered cash for all outstanding target shares. The acquiring corporation borrowed some of the money used to acquire those shares, and then merged into the target, with the target corporation assuming its debts. The IRS here concluded that the target bears the economic burden to repay the loans used to acquire its stock. Therefore, said the IRS, the acquiring corporation should be considered the conduit of the target. The IRS also advised that:
The payments to the target shareholders for the cancellation of
their stock options are not expenses connected with the redemption, and
therefore were deductible;
The target severance payments were made for the performance of services
not in connection with the redemption, and were therefore deductible; and
The cost of terminating the stock options that vested because of the acquisition and merger were also deductible.
Watch Out for Redemption Characterization
Although most practitioners are sensitive to the Section 162(k) restrictions on redemptions and the expenses made in connection therewith, probably most practitioners would not easily see the redemption issue in Field Service Advice 1998-419 (discussed immediately above). The fact that a purchase of target stock, followed by its merger into the acquiring corporation, would be viewed as a redemption might surprise some practitioners.
Nonetheless, at least in the Service's view, this allows it to employ one of its more effective devices to whittle down what otherwise may be a long list of deductions in the transaction.
Redemption Expenses Nondeductible: Avoiding Redemption Characterization, Vol. 7, No. 7, The M&A Tax Report (February 1999), p. 7.