The following article is adapted from reprinted from the M&A Tax Report, Vol. 8, No. 1, August 1999, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

One of the more obscure (but still important) provisions enacted as part of the Taxpayer Relief Act of 1997 was Section 163(l). Far from providing any kind of relief to taxpayers (no matter how you spell "relief"), this provision denies a tax deduction even if it is otherwise allowable under Section 163, for interest paid or accrued on what is termed a disqualified debt instrument. This provision in the 1997 law is generally effective for debt instruments issued after June 8, 1997. Section 163(l) was foreshadowed by the IRS' issuance of Notice 94-47, in which it expressed unmitigated hostility toward permitting an interest deduction with respect to purported debt instruments that would be defrayed through the issuance of equity in the supposed debtor.

The IRS apparently felt that such an instrument was simply a disguised (and delayed) issuance of equity. Before the actual delivery of the equity, the IRS felt that the instrument's claim to true debt status (on which interest paid or accrued would be deductible) should be denied. It was just too early. It wasn't soup yet.

Section 163(l) codifies this line of reasoning by simply denying an interest deduction on interest paid or accrued with respect to a new category of debt: a disqualified debt instrument issued by a corporation. For this purpose, "disqualified debt" is defined as indebtedness of a corporation that is payable in equity of the issuer or of a related party. A related party for this purpose is as defined in either Section 267(b) or Section 707(b).

Bad Debt?

This new category of debt can truly be regarded as a type of "bad" debt, although this new category does not even qualify for any type of deduction. Debt is regarded as payable in equity in cases in which a substantial amount of the principal or interest is required to be determined by reference to the value of the equity, and even where receipt of the equity is at the holder's option and the facts and circumstances of the issuance suggest that the holder is "substantially certain" to exercise his or her option.

There are actually three categories of indebtedness in the statute (Code Section 163(l)(3) that are considered as disqualified. Indebtedness is treated as payable in equity of the issuer or a related party only if:

Link to Stock Value

Presumably, this latter clause is not as expansive as it seems. It appears designed to ensnare cases, as illustrated in Revenue Ruling 83-98 where the instrument's holder is economically compelled to accept equity. This economic compulsion to take the equity can happen where the instrument features a variable payment schedule calling for the holder to receive a larger payment if, instead of choosing to receive cash, the holder selects the equity payment option. After all, bigger is usually better.

Notice 94-47, 1994-1 C.B. 357, did exempt from its ambit the capital notes described in Revenue Ruling 85-119, 1985-2 C.B. 60. Hopefully, Section 163(l) will be interpreted as having the same scope. In Revenue Ruling 85-119, a corporation issued notes and, at their maturity, the corporation was unconditionally obligated to issue stock having a value equal to the principal amount of the notes. However, for noteholders who did not elect stock, the corporation was unconditionally obligated to effect a secondary offering and to sell sufficient stock to result in the receipt of proceeds equal to the principal amount of the notes.

Revenue Ruling 85-119 noted that, in form, the notes were payable in stock. Hence, even under the law then existing, these notes were vulnerable to recharacterization as disguised equity. Nevertheless, the IRS took cognizance of the election procedure available to noteholders that required an affirmative election, on their part, to accept such equity, and blessed these notes as true debt instruments. Because the noteholders could force the debtor to effect a secondary offering of its stock, the ruling found that notes were valid debt. In substance, these notes were payable, at the holder's option, in a fixed amount of cash or in stock of equivalent value.


The consequences of the disqualified debt moniker are not good ones—the denial of otherwise allowable interest deductions. Hopefully, there will be guidance from the Service sometime soon on the tax position applying to these instruments. Although running the gauntlet of disqualification may not be desirable, the type of capital notes described in Revenue Ruling 85-119. After all, paying off notes with stock can be attractive.

Disqualified Debt Instruments, Vol. 8, No. 1, M&A Tax Report (August 1999), p. 1.