Taxability of fees in financing a stock redemption.

On Oct. 29, 1992, the Arizona District Court reversed a lower Bankruptcy Court decision that allowed corporations to amortize and deduct loan-related fees (including attorneys' fees and other loan commitment fees), over the life of a loan incurred in financing a stock redemption. The district court in In re Kroy (Europe) Limited, DC Ariz., 1992, rev'g Bankr. D. Ariz., 1992, held that Sec. 162(k) does not allow a corporation to deduct any loan and administrative fees incurred in connection with a corporation's redemption of its stock. Previously, the courts and the IRS had determined that a corporation may amortize and deduct loan fees related to acquiring a loan over the life of the loan. Now, the district court has found that Sec. 162(k) supersedes this prior case law and requires the taxpayer to capitalize any expenditures causally related to a stock redemption. The court's decision in this case overturned over 30 years of precedent that had mandated examination of the costs' origin, rather than the taxpayer's purpose, in ascertaining the deductibility of corporate expenditures. Unfortunately, the court did not fairly consider the judicial or legislative history of Sec. 162(k) in arriving at its decision. The Service now has complete discretion in determining which expenditures are related to a redemption and which are not. Further, the court has given taxpayers no real guidance in this matter.

Kroy became a private company in a leveraged buy-out transaction when it merged with another company to form a new Kroy. Bankers Trust assisted in obtaining $78 million in loans for the stock buyback and charged subsequent debtor Kroy advisory fees of $1.8 million and a placement fee of $655,000. Additionally, debtor Kroy incurred other fees equaling $2.27 million for accounting, legal and other services, for a total of $4.1 million in amortizable loan costs relating to the stock buyback. Kroy treated $1.825 million (the costs incurred in the actual course of the stock redemption) as nondeductible capital expenditures.

The IRS argued that Sec. 162(k) prevented Kroy from deducting the financing and service costs of procuring the loan because Kroy paid these costs in connection with the redemption of its stock. The proper treatment of these costs, according to the Service, was capitalization without any amortization.

Sec. 162(k) provides that "no deduction, otherwise allowable, shall be allowed under this chapter for any amount paid or incurred by a corporation in connection with the redemption of its stock." The IRS's primary contention was that Kroy incurred these loan-related costs in connection with the redemption because the stock buy-back could not have occurred without the availability of these funds. In essence, the Service argued that the taxpayer's purpose in obtaining the loans and the allocation of the proceeds should be the determining factor for expense deductibility. Moreover, the IRS suggested that the applicable test be a simplistic "but-for" test to determine whether the taxpayer paid the costs in connection with a stock redemption. "But-for" the stock redemption, the Service contended, Kroy would neither have acquired the loans nor incurred the loan-related fees.

Prior case law differentiated between obtaining loans and using the loan proceeds. The IRS and the Tax Court have always treated loan fees as amortizable over the life of the loan. In addition, well-established authority holds that loan fees are associated with, and have their origin in, the loan transaction. As held by the Tax Court in Anover Realty Corp., 33 TC 671 (1960), loan fees do not have their origin in the subsequent transaction in which the taxpayer uses the loan proceeds to acquire other property.

In dismissing the Service's claims that Sec. 162(k) applied, the Bankruptcy Court in Kroy reiterated that examining Kroy's purpose for acquiring the loans was difficult, and that the correct analysis was based on the origin of the transaction, not the use of the proceeds. In this case, the origin of the loan fees was in the actual loan transaction, not the stock redemption. In addition, the Bankruptcy Court examined the legislative history of Sec. 162(k) and found that Congress intended it to apply solely to expenses incurred in connection with redemptions in the hostile takeover area. Because Kroy's redemption was not in response to a hostile takeover, the court held that Sec. 162(k) did not apply.

On appeal, the district court found that Sec. 162(k) applies to all expenses incurred with any redemption. To support its finding, the court stated that the plain language of the statute should be relied on unless it is at odds with the intention of the drafters. Although the district court found that congressional reports did show that the enactment of Sec. 162(k) was meant to clarify prior law relating to the deductibility of fees in hostile takeovers, the court reasoned that Congress did not enact Sec. 162(k) only to clarify prior law and, by applying the statute as written, it would not conflict with the intention of the drafters.

The district court may have misconstrued the intent of the drafters. There is nothing in Sec. 162(k)'s legislative history to suggest that Congress even considered, much less intended to change, the long-standing deductibility of loan fees on an amortized basis over the life of the loan. The legislative history indicates that the provision was intended only to clarify prior law relating to deductions in the hostile takeover area. Moreover, in the only case interpreting this provision, the IRS prevailed on grounds that Sec. 162(k) was not a change, but merely a clarification of existing law (Stokely-Van Camp, Inc., 21 Cl. Ct. 731 (1990)).

The most obvious indication that Congress intended only to clarify prior law is the revenue neutrality of the provision. Congress expressly stated that enactment of Sec. 162(k) should not increase revenue. However, by applying the district court's statutory interpretation, the Treasury Department should anticipate a significant increase in revenues due to the disallowance of loan cost amortization in the stock redemption setting.

What is most troubling about the district court's holding is its misinterpretation of precedent and instant dismissal of prior cases. Kroy contended that a long line of cases showed that a court can never look at the taxpayer's use of loan proceeds to determine whether loan fees and expenses are deductible. The court's opinion brushed aside these cases by stating that this prior precedent did not apply to this set of facts. The court obviously examined only the taxpayer's purpose in acquiring the loan, in contravention of established precedent.

Currently, Kroy is on appeal to the Ninth Circuit. If affirmed, this decision could create a slippery slope for future expense treatment. Indeed, the effects of this decision are wide-ranging. As the Supreme Court stated in Woodward, 397 US 572 (1970), examining a taxpayer's purpose in entering into a transaction is difficult and uncertain. On the basis of the district court's decision, taxpayers could manipulate the purpose of obtaining loan proceeds and circumvent the proper tax treatment. Also, if a corporation procures a sizable loan at the approximate time of a stock redemption, how would the IRS discern whether the corporation used the proceeds for the redemption or for other capital expenditures? The only manner in which the Service can adequately police the application of the proceeds is to trace the funds. This, however, is difficult, if not impossible. The Kroy decision has opened the door for the IRS to use its complete discretion in assigning loan proceeds to assets. For example, would the "but-for" test apply to a refinancing of debt originally incurred to fund a redemption and thus to the costs associated with such financing? Also, why,should a corporation with enough cash to fund a redemption be treated differently than one that has to borrow to fund a redemption? Because of these (and many other) questions, the authority given to the IRS will create allocation disputes, timing problems and, in the end, considerable litigation.

Vigorous application of the Kroy dicta could also have anticompetitive effects. Sec. 162(k) disallows a deduction for amounts paid by a corporation in the redemption of its stock. This prohibition leaves the corporation at a distinct disadvantage during hostile takeovers because a corporate raider may raise funds and deduct loan fees to purchase a target's stock, while the target may not. Thus, the statute gives preferential treatment to outside bidding parties. In addition, the Kroy decision will affect corporate management efficiency when the goal of a redemption is to purchase the stock of disgruntled minority shareholders. Sec. 162(k), as construed by the Kroy court, may increase the cost of financing a redemption to the point where corporations cannot afford to change their ownership structure, thus leaving a possibly inefficient management team in place.

A broad examination of the nondeductibility of loan fees leads to the conclusion that this interpretation of Sec. 162(k) could affect the financial markets. The disallowance of loan fees effectively increases the cost of capital in the same manner as points increase the effective rate of financing. Business entities would be less inclined to borrow capital to fund redemptions, leading to a less efficient capital market and a possible impairment of economic growth.

If the Ninth Circuit affirms the district court, tax consultants and preparers should be aware of the implications of the Kroy decision before suggesting specific financing vehicles for funding stock redemptions. If possible, corporations should redeem stock when a healthy supply of cash is on hand rather than exploring the debt markets for financing. Because loan costs are prohibitively expensive, corporations should take into account the true economic costs of purchasing treasury stock.