New ruling on debt capital deductions.

The Tax Court decided in Fort Howard Corp. v. Commissioner in August 1994 that fees incurred to obtain debt capital used to buy back stock could not be deducted. However, the court's decision directly contradicts a June 1994 Ninth Circuit Court ruling on the same issue (U.S. v. Kroy). If the Tax Court decision is upheld on appeal, the stage will be set for a Supreme Court resolution of the conflicting court decisions and a period of uncertainty pending adjudication.

Although both cases dealt with leveraged buyouts, the issue is broader because it extends to any debt-financed buyback of shares. The Fort Howard decision is in accordance with Internal Revenue Code section 162(k), which says expenses cannot be deducted if they are incurred "in connection with" a buyback. Fort Howard argued the fees were an interest expense and thus were deductible. The court acknowledged that interest expense on debt incurred in connection with a buyback is deductible because interest is a financing cost. However, it concluded the section 162(k) prohibition on deduction extended to the financing costs associated with bridge loans and permanent financing because such debt was part of Fort Howard's redemption plan and the buyback and the permanent debt's issuance were only eight days apart. Thus, the fees for arranging the financing were part of the cost of raising the debt capital and not, as Fort Howard argued, a deductible interest expense.

Observation: Interest is compensation, and there is a relationship between it, the principal borrowed and the designated payment time period. The fees were received without regard to the dollar amount of debt capital purchased or the period during which the notes were outstanding. Therefore, they could not be characterized as rent for the use of funds and, in fact, were fees for services.