IRS applies Sec. 162(k) to deemed stock redemption.

In Letter Ruling (TAM) 9342005, the Service held that the acquisition of Taxpayer's (T) stock by Newco, followed immediately by the downstream merger of Newco into T, in which T assumed all of the indebtedness incurred to acquire its stock, constituted a redemption by T. The IRS further held that all of the loan costs were incurred "in connection with" the redemption and, as a result, disallowed the deduction taken for the capitalized loan costs under Sec. 162(k).

The Service used a substance over form analysis to hold that the stock purchase followed by a downstream merger was a redemption. in reaching its conclusion, the IRS stated that Newco never acquired beneficial ownership of the T stock, never derived an economic benefit from the stock and was never liable under the debt obligations.

After determining that the transactions should be treated as a redemption, the Service applied Sec. 162(k) broadly and held that the loan costs were not deductible. Citing In re Kroy (Europe) Ltd., DC Ariz., 1992, the IRS held that Sec. 162(k) applied to disallow all expenses directly or indirectly incurred "in connection with" a redemption. Because the loan proceeds were used to acquire T's shares, the Service treated them as incurred "in connection with" the deemed redemption. (It should be noted that the Bankruptcy Court's decision in In re Kroy (Europe) Ltd., Bankr. Ariz., 1992, had held that loan fees were part of a separate transaction, and that the taxpayer could amortize and deduct the loan costs.)