1994 Letter Ruling revokes a 1981 Letter Ruling.

In Letter Ruling 9410040, the Service revoked Letter Ruling 8108104, issued some 13 years ago. The transaction described in the 1981 ruling involved a sale of debentures outside the United States by a foreign subsidiary (FS). The subsidiary then lent the proceeds to its U.S. Parent to finance worldwide operations. The debentures were (1) unsecured, (2) in bearer form, (3) convertible into Parent stock and (4) guaranteed by Parent. The obligation represented by the debentures was not canceled on conversion. By its express terms, a converted debenture was not further convertible into Parent stock. FS was never engaged in a U.S. business and it never filed a Federal income tax return.

Letter Ruling 9410040 stated as its reason for revocation only that "the prior letter ruling is in error." However, it did not explain which holding in the ruling was in error. There were only three: Parent would recognize no gain or loss on the issuance of its stock for the debentures (Sec. 1032); Parent's basis in the debentures would equal the fair market value (FMV) of its stock issued in the exchange (Sec. 1012); and any future sale or disposition by Parent of the debentures would result in gain or loss (Sec. 1001). These holdings seem rather innocuous, unless the Service is now questioning its analysis of the underlying transaction.

Questions about the analysis implicit in the ruling are legion. Presumably, Parent transferred the right to obtain its stock before the debenture sale. If so, should that transfer have been respected for tax purposes even though the holding of that property right by FS was merely transitory? Stated another way, if the transfer of the option was an integral part of the debenture issuance, should the option component have been viewed by the Service as having been sold directly by Parent to the purchasers of the debentures? Alternatively, if the form of the transaction is respected, does FS have a zero basis in the option? If so, is there gain to FS (subpart F income) when it sells this zero basis "right" (security) to the public? Does the fact that the transferee corporation is foreign mean that there are Sec. 367 concerns that should have been addressed? Should income have been allocated to Parent for its services as guarantor of the FS indebtedness? Because the conversion right automatically expires on the exercise of the conversion privilege, should Parent's basis in the debenture have been increased for the portion of the stock attributable to the conversion option? Should the IRS even have respected FS as the issuer of the debenture for tax purposes, or should it have treated FS as Parent's agent or nominee with respect to the issuance?

It may be, however, that the revocation had nothing to do with the analysis. Perhaps the Service is simply troubled by the tax results flowing from the transaction. After first concluding that Parent's basis in the debenture was equal to the value of the stock issued in the conversion, the ruling concluded that Parent would recognize "gain or loss" on a subsequent sale or exchange of the debenture. The reference to "gain" is illusory in this transaction, and can be ignored. If the conversion privilege was exercised, Parent's increase in basis in the debenture would typically generate a tax loss on the subsequent disposition of the debenture.

Example: FS sells a debenture at its face value of $10x. The debenture is convertible into one share of Parent stock (also worth $10x). At the time of conversion the value of Parent stock has doubled. Applying the holdings of Letter Ruling 8108104, Parent will obtain a $20x basis in the debenture (FMV of its share of stock), which will result in a $10x loss on the subsequent disposition of the debenture (no longer convertible) for $10x (its face value).

Another possibility is that the revocation was precipitated by the forthcoming proposed regulations under Sec. 7701(l), added to the Code by the Revenue Reconciliation Act of 1993 (RRA). The RRA Conference Report grants broad regulatory authority to the Treasury to recharacterize a financing transaction that uses multiple entities to avoid U.S. withholding tax. The financing transaction described in the 1981 ruling resulted in complete avoidance of U.S. withholding tax on interest payments made by FS. In light of Sec. 7701(L), perhaps the Service now feels that FS was a conduit entity used principally for avoiding U.S. withholding tax and that FS, therefore, should have been ignored for tax purposes.