Deductibility of loan fees in light of conflicting judicial opinions.

In mid-1994, the Tax Court and the Ninth Circuit reached opposite conclusions on whether loan financing fees relating to stock redemptions were deductible under Sec. 162(k). Since this area of the law is unsettled, taxpayers should look closely at the application of Sec. 162(k) in making decisions concerning appropriate tax return filing positions.

Sec. 162(k)

In general, Sec. 162(k) was enacted in 1986 for the purpose of disallowing otherwise deductible expenses incurred by a corporation "in connection with the redemption of its stock." Exceptions are provided in Sec. 162(k)(2) for deductions relating to interest expense allowable under Sec. 163, dividends paid under Sec. 561, and any expenses incurred with respect to stock redemptions by certain regulated investment companies. Examples provided in Sec. 162(k)'s legislative history of the types of expenses applicable include amounts paid to repurchase stock; any premiums paid for such stock; and other expenses such as legal, accounting, brokerage, transfer agent and appraisal fees incurred as part of a redemption; or any expenses so related.

Overview of judicial precedent

The statutory language of Sec. 162(k) that seems to have divided the courts is the phrase "in connection with the redemption of its stock." In Kroy (Europe) Limited, 27 F3d 367 (9th Cir. 1994), it was held that fees incurred in connection with obtaining financing used by a taxpayer to redeem its outstanding stock were capital expenditures associated with the financing arrangements; as such, they could be amortized and deducted ratably over the term of the outstanding loans and debt securities. (This decision reversed a district court ruling.)

In reaching its conclusion, the Ninth Circuit held that the appropriate test to be applied in determining deductibility of loan fees is the "origin of the claim" test (derived from Gilmore, 372 US 39 (1963), and expanded in Woodward, 397 US 572 (1970), and Hilton Hotels Corp., 397 US 580 (1970)). The Ninth Circuit concluded that the origin of the fees was the financing arrangements (i.e., the borrowing transaction) which, while related to the transaction, were "separate and independent" from the redemption transaction. In essence, the court bifurcated the leveraged buyout into separate transactions--the financing arrangement and the stock redemption.

In contrast, just weeks later, the Tax Court ruled, under similar facts, in Fort Howard Corp., 103 TC 345 (1994), that such expenses were not deductible under Sec. 162(k). The Tax Court concluded that the financing arrangements were an integral and inextricable part of the overall plan of redemption; the financing was just one of several steps leading to the stock redemption transaction. In support of its conclusion, the Tax Court looked to agreements between Fort Howard and its bankers, which made the availability of funds contingent on the successful completion of the redemption transaction. In declining to follow Kroy, the Tax Court explained that the Ninth Circuit had failed to analyze the phrase "in connection with" and instead had relied on "other doctrines not referred to in the statute" (i.e., the origin of claims test).

The Tax Court opinion was reviewed by the entire court, producing a 15-2 split. In the dissenting opinion, Judge Beghe argued that the true issue to be resolved was whether the existence of a direct cause and effect relationship between the debt and the fees paid to obtain the debt proceeds was sufficient to override the indirect relationship of such fees to the stock redemption. Judge Beghe stated that his conclusion was based on "well-settled principles of tax law" that require that fees paid to obtain financing must be capitalized and amortized over the period of the outstanding debt to which they relate.

What's next?

Fort Howard has announced that it will appeal--probably to the Seventh Circuit. If the appeal is decided in favor of the IRS, the stage is set for review by the Supreme Court. If Fort Howard appealed to the Supreme Court, the Department of Justice would, no doubt, notify the Court of its agreement for review. On the other hand, if the Seventh Circuit concurs with the Ninth Circuit, the Service will likely continue with further litigation in other circuits. In the meantime, the IRS will continue disallowing these expenses. If the Service and Justice are ultimately unsuccessful in litigation, the Treasury could ask for legislation.

Tax return issues

To the extent the statute of limitations (SOL) remains open, refund opportunities may exist for taxpayers that filed returns or settled IRS examinations in accordance with the district court's Kroy decision, which was in favor of the Service. In general, as provided by Sec. 6511(a), the SOL is open for filing a refund claim if the claim is filed within three years from the date the original return was filed or, if later (as in the case of an audit settlement), within two years from the date that the tax payments sought to be refunded were made. Refund claims filed by taxpayers should be field as protective refund claims in order to bar expiration of the SOL to the extent applicable.

By reviewing the limitations periods applicable to prior year tax returns and audit settlements, taxpayers may be able to protect themselves and possibly obtain refunds, if timely claims are field in accordance with the Ninth Circuit's decision in Kroy. Of course, care should be exercised when filing any amended return in order to avoid unnecessary exposure to other issues.