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New Sec. 163(l) is a major trap for the unwary. (Internal Revenue Code s. 163(l)).

It is common for banks, insurance companies and other lenders to obtain an equity kicker, usually in the form of contingent interest, in major loan transactions--especially those involving mezzanine financing. A literal reading of Sec. 163(1), enacted as part of the Taxpayer Relief Act of 1997 (TRA '97), and generally effective for debt instruments issued after June 8, 1997, may cause the disallowance of all interest paid on corporate debt instruments that contain any contingent interest determined by reference to the issuer's or a related party's profits or equity. Even a liberal interpretation of Sec. 163(l) would result in disallowance of the contingent interest portion of the debt payments. The disallowance of interest will make such financing much more expensive than anticipated and can, in some situations, make the loan unfeasible.

Sec. 163(l)(1) provides that "No deduction shall be allowed ... for any interest paid or accrued on a disqualified debt instrument." The term "disqualified debt instrument" means any indebtedness of a corporation payable in equity of the issuer or a related party (Sec. 163(l)(2)).

The House Ways and Means Committee Report explains Sec. 163(l)(1) and (2) as follows:

no deduction is allowed for interest or OID [original issue discount] on an instrument issued by a corporation (or issued by a partnership to the extent of its corporate partners) that is payable in stock of the issuer or a related party (within the meaning of sections 267(b) and 707(b)).

Thus, the question arises whether the phrase "that is payable in stock of the issuer or a related party" relates to the phrase "no deduction is allowed for interest or OID" or the phrase "an instrument issued by a corporation."

Under Sec. 163(l)(3), debt is treated as payable in equity of the issuer or a related party only if.

A. A substantial amount of the principal or interest is required to be paid or converted (or at the option of the issuer or a related party, is payable in or convertible) to such equity;

B. A substantial amount of the principal or interest is required to be determined (or at the option of the issuer or a related party, is determined) by reference to the value of such equity; or

C. The indebtedness is part of an arrangement reasonably expected to result in a transaction described in A or B.

This type of arrangement could include certain issuances of a forward contract in connection with the issuance of debt, nonrecourse debt secured principally by the issuer's or related party's stock, or certain debt instruments convertible at the holder's option when it is substantially certain that the right will be exercised. The House Report states that, "For example, it is not expected that the provision will affect debt with a conversion feature where the conversion price is significantly higher than the market price of the stock on the issue date of the debt."

For purposes of A, B and C, the Conference Report clarifies that principal or interest is treated as required to be paid in, converted to or determined with reference to the value of equity, if it may be so required at the option of the holder or a related party and there is a substantial certainty that the option will be exercised.

This new law does not affect the treatment of an instrument's holder.

Many borrowers and lenders may not have focused on these new rules, which also may affect existing loans that are materially modified.
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Author:Collins, M. James
Publication:The Tax Adviser
Date:May 1, 1998
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