Technical correction clarifies sec. 162(k) limit on stock reacquisition expenses.

Section 1704(p) of the Small Business Job Protection Act of 1996 (SBJPA) provides much-needed clarification on the Sec. 162(k) limitation on stock reacquisition expenses. First, the SBJPA added new Sec. 162(k)(2)(A)(ii), effective as of the effective date of the Tax Reform Act of 1986 (TRA), clarifying that financing costs are not subject to disallowance. Second, the SBJPA clarified that Sec. 162(k) applies to any reacquisition of previously outstanding stock, regardless of whether the transaction is treated for tax purposes as a redemption, a sale of stock, a dividend, a reorganization or any other transaction. This second "clarification" applies only to amounts paid or incurred after Sept. 13, 1995.

Legislative History of Sec. 162(k) Prior to 1996, there was no authority that would allow a corporation to deduct, either currently or through amortization, costs associated with a redemption of its stock other than at the end of the corporations life. However, in Five Star Manufacturing Co., 355 F2d 724 (1966), the Fifth Circuit allowed a corporation to deduct expenditures related to the redemption of a shareholder's stock, including the cost of the redeemed shares. The peculiar facts in Five Star involved a shareholder who threatened liquidation of the corporation unless his stock was repurchased. In allowing a deduction for the redemption, the court noted that the liquidation of the corporation was imminent without the removal of the shareholder.

Limited by its facts and questioned as to its validity, Five Star was an isolated case whose main contribution to the world of tax was the creation of uncertainty as to the proper treatment of costs incurred by a corporation to redeem a problem shareholder.

During the leveraged buyout boom of the early 1980s, many corporations were the targets of hostile takeovers. Noting the decision in Five Star, these corporations started deducting the substantial expenditures incurred to repurchase stock from hostile shareholders (so-called "greenmail" payments). Obviously, this did not please the government. As a result, Congress added Sec. 162(1).

Reclassified as subsection (k) in 1988, Sec. 162 (k) codified the general rule of case law that a redemption of stock is a capital transaction and, as such, stock redemption expenses are not deductible. The legislative history of Sec. 162(k) specifically refers to Five Star and indicates that Sec. 162(k) was enacted to clarify, by way of an express statutory provision, any uncertainty regarding the deductibility by a corporation of costs associated with a redemption of its stock.

The Ninth Circuit Versus the Tax

Court

Sec. 162(k) states that "any amount paid or incurred by a corporation in connection with the reacquisition of its stock" is not deductible. Exceptions to the general rule are provided, including an exception for amounts allowable under Sec. 163 (relating to interest).

In a Ninth Circuit case, Kroy (Europe) Limited, 27 F3d 367 (1994), Kroy decided to go private through a leveraged buyout. To finance the acquisition of its stock, Kroy borrowed approximately $60 million. To obtain this financing, Kroy paid over $4 million in loan fees to lenders and investment bankers, which it sought to recover through amortization.

The Service audited Kroy and disallowed the deduction for the loan fees. The IRS's primary argument was that Sec. 162(k) applied to disallow a deduction for loan fees because the fees were incurred "in connection with" a redemption of Kroy's stock.

Kroy argued that, for Federal tax purposes, the transaction to which the loan fees related (i.e., the borrowing of $60 million) was a separate and independent transaction from the redemption of Kroy's stock. Kroy contended that it did not incur the loan fees in connection with the reacquisition of its stock, but as compensation for the services rendered by its lenders and investment bankers in order to borrow the $60 million.

The court agreed with Kroy. Citing Gilmore, 372 US 39 (1963), and Woodward, 397 US 572 (1970), the court took the position that the underlying purpose for borrowing the $60 million (i.e., to finance a stock redemption) was irrelevant in determining the deductibility of the $4 million of loan fees. The court reasoned that the enactment of Sec. $162(k) was intended to overrule the decision in Five Star and was never intended to disallow deductions for costs incurred in borrowing funds when the loan proceeds are used to redeem stock.

In a Tax Court reviewed decision, Fort Howard Corp., 103 TC 345 (1994), Fort Howard borrowed over $2 billion to finance a leveraged buyout of its stock. To obtain this financing, Fort Howard paid Morgan Stanley a transactional fee. Fort Howard treated $36 million of the amount paid to Morgan Stanley as a loan fee and allocated it over the various debt instruments issued in the transaction. A deduction was taken as the debt was amortized or retired.

The Service audited Fort Howard and disallowed the deduction for the loan fee. As in Kroy, the IRS's primary argument was that Sec. 162(k) applied to disallow a deduction for the loan fee because the fee was incurred "in connection with" a redemption of Fort Howard's stock.

The Fort Howard case was decided two months after the Kroy case. The court acknowledged the decision in Kroy, but rejected the Ninth Circuits analysis under die primary purpose doctrine and ruled that Sec. 162(k) precluded Fort Howard from deducing any of the $36 million loan fee.

In siding with the Service, the court stated that its decision turned on the interpretation of the phrase "in connection with" under Sec. 162(k). The court stated that the words of the Code should be interpreted in their ordinary, everyday sense. The court further stated that the words "in connection with" have historically been interpreted broadly for Federal tax purposes and that events or elements are "connected" when they are logically related. The court then stated that a logical relationship existed between Fort Howard's redemption, the corresponding need for financing and the costs incurred to obtain the financing. Based on this reasoning, the $36 million loan fee was incurred "in connection with" the redemption of Fort Howard's stock.

Citing the legislative history of Sec. 162(k), Fort Howard noted that the Conference Report stated that the words "in connection with" were "not intended to deny a deduction for otherwise deductible amounts paid in a transaction that has no nexus with the redemption other than the approximate time or arising out of the same general circumstances." Relying on case law on the capitalization of financing costs, Fort Howard asserted that there was no nexus between the procurement of the $2 billion in financing with its redemption "other than its temporal and circumstantial property."

The court rejected this argument on the grounds that nexus did exist between the procurement of the $2 billion and the redemption in that the financing arose solely because of the redemption.

The SBJPA

New Sec. 162(k)(2)(A)(ii) effectively ends the debate created by the conflicting results reached in Kroy and Fort Howard, by providing an exception to the general disallowance rule of Sec. 162(k) for any "deduction for amounts which are properly allocable to indebtedness and amortized over the term of such indebtedness." Congress made it clear that Sec. 162(k) was never intended to disallow such amounts by making this provision effective as if included in the TRA.

New Matters

On Oct. 22, 1996, the Tax Court issued a new opinion supplementing Fort Howard, which took into consideration new Sec. 162(k)(2)(A)(ii). The court stated that, "in light of this statutory modification," the court now holds that Sec. 162(k) does not preclude Fort Howard from deducting the fee it paid to Morgan Stanley, as long as the fee is properly allocable to the $2 billion of debt.

This unusual action by the Tax Court highlights the opportunity for filing refund claims for taxpayers that did not take deductions for leveraged buyout fees properly allocable to indebtedness to be amortized over the term of such indebtedness.