Cash settlement did not turn forward-contract issuance costs into an abandonment loss

Plain-English summary

The IRS considered whether a corporation could deduct as a § 165 loss issuance costs allocated to forward contracts on its own stock. The corporation argued that the contracts had been abandoned because they were settled for cash instead of stock. The IRS concluded that the cash settlement completed the same forward contracts, produced value for the issuance costs, and did not create an abandonment loss. It also explained that the prior § 1032 ruling treated the cash settlement as economically equivalent to issuing and immediately repurchasing the stock, so the corporation could not take inconsistent positions for the proceeds and the costs.

Ruling snapshot

• Question: May issuance costs allocated to forward contracts on a corporation's own stock be deducted as a § 165 loss when the contracts are cash settled?
• Outcome: Advice given
• Key authorities: IRC §§ 1032, 165, and 263; Treas. Reg. §§ 1.165-2 and 1.263(a)-5; PLRs 200450016 and 200518062.

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201025047
       Release Date: 6/25/2010
       CC:CORP:B05:ROBurch
       PRESP-107900-10

UILC: 1032.00-00, 165.00-00, 263.00-00

date: March 22, 2010

 to:   C. Glenn McLoughlin
       Senior Counsel (Oklahoma City, Group 2)
       (Large & Mid-Size Business)

from: Rebecca O. Burch
General Attorney, Branch 5
(Corporate)

       Debra L. Carlisle
       Branch Chief, Branch 5
       (Corporate)

subject: The effect of a cash settlement on the deductibility of issuance costs for a forward
contract on the issuer's own stock

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.


       LEGEND


       Taxpayer = -------------------------------------------------------------------------------------------------
                  -------------------------------------------------------------------------------------------------
                  ------------------------

       Date1         = -------------------------

       Date2         = --------------------------

       Date3         = -------------------------

PRESP-107900-10 2

Date4 = -------------------------

TY1 = -------

TY2 = -------

w# = -------------

x# = -------------

y = ----

z = ----

$m = --------------

$n = -----

$N = ---------

$o = -----

$p = -----

$q = --------

$r = --------------

$s = --------------

ISSUE

   Does the section 1032(a) ruling in PLR 200450016 (“the PLR”) (supplemented by

PLR 200518062), which addresses the cash settlement1 of a forward contract on
Taxpayer’s own stock, support Taxpayer’s position that stock issuance costs may be
deducted as a loss under section 165 because Taxpayer asserts that it did not issue
stock pursuant to the forward contract?

1
The use of the phrase “cash settlement” in this CCA is discussed in section B. of LAW AND ANALYSIS.

PRESP-107900-10 3

CONCLUSIONS

   The PLR does not support Taxpayer’s position. First, the ruling addresses the

application of section 1032(a) to gain realized by Taxpayer for money received to settle a
forward contract involving its own stock. Issuance costs were not mentioned in the
PLR nor did taxpayer raise these costs in its request for the PLR. Second, in the PLR,
section 1032(a) applied to the transaction because the cash settlement of a forward was
treated as if Taxpayer issued its stock to complete the forward. Third, the PLR
determined that there was a gain on the forward; any costs attributable to the forward
would have to be netted against any gain on the forward to determine overall gain or
loss. Fourth, a section 165 loss can be taken for a loss incurred in a transaction that is
later abandoned. Here, Taxpayer did not abandon the forward contract. Taxpayer
received cash on the forward, and, including the issuance costs, there was an overall
gain.

FACTS FROM PLR 200450016

   The Investment Units
   In TY1, Taxpayer issued w# investment units (Units) to investors. Each Unit had

an issue price of $n and consisted of a Forward Contract on Taxpayer’s own stock and
a Note issued by Taxpayer. The issue price of $n was allocated entirely to the Note.

   Under the Forward Contract, Taxpayer would deliver on the maturity date one

share of its common stock in exchange for each investor’s payment of $n (the Forward
Price). Investors received a quarterly fee of y percent of the Unit’s value. Investors
could settle the Forward Contract in cash prior to the maturity date. The Forward
Contract’s maturity date was Date1.

     Under the Note, Taxpayer paid each investor z percent interest on the $n

principal Note. Before the Note was due, Taxpayer was required to try to remarket
(resell) the Note on behalf of each investor. The first attempt was due on Date2, and
required Taxpayer to remarket the Note for a price that would pay the $n Forward Price.
If this attempt failed, Taxpayer would have to attempt a second remarketing on Date3.
If the second attempt failed to yield the appropriate proceeds, each investor was able to
deliver the Note as payment under the Forward Contract. The Note was due Date4.

     Rulings and Exchange Offer
     By TY2, Taxpayer’s stock value had decreased to $o (the numbers have been

simplified throughout this discussion) and its credit rating had declined. This made it
difficult for Taxpayer to remarket the Notes. Taxpayer wanted to satisfy its obligations
under the Units before the first remarketing was due. In addition, Taxpayer was in a
gain position on the Forward Contracts (because Taxpayer’s stock value was less than
the Forward Price), and the investors were in a loss position. To induce the investors to
complete the Forward Contracts before the remarketing was due, Taxpayer made the
offer to the investors to reduce the Forward Price to $N instead of the original Forward

PRESP-107900-10 4

Price of $n, and complete the Forward Contracts with cash. Reducing the Forward
Price had the effect of decreasing by a small portion the loss the investors would realize
on the Forward Contracts. The submission Taxpayer submitted in its ruling request
provided the approximate amounts that the investors would pay Taxpayer to “cash
settle” the Forward Contracts.

ISSUANCE OF PLR 200518062

   After receiving its ruling letter, Taxpayer requested a supplemental PLR to

update the final numbers and values from the Exchange Offer. The supplemental
request did not seek a ruling on the possibility of deducting the issuance costs at issue
here. The supplemental PLR, as with the initial PLR, contained the standard no opinion
language. The supplemental PLR also made no opinion about “effects resulting from,
the proposed transaction that are not specifically covered by the above ruling or those
rulings set forth in the Prior Letter Ruling.”

THE CURRENT DISPUTE

   The Service and the Taxpayer agree that there were issuance costs allocable to

the Forward Contact portions of the Units. The dispute is about whether the issuance
costs allocated to the Forward Contract portions of the Units are deductible as losses
under section 165. Taxpayer asserts that the costs are deductible because they were
incurred for a transaction that was abandoned. On its TY2 tax return that included the
year the Exchange Offer was completed, Taxpayer allocated all of its capitalized
issuance costs to the Note portion of the Units. Since its original return, TP agreed with
Exam to allocate $r of its total capitalized issuance costs to the Forward Contract
portions of the Units. Of the $r allocated to the Forward Contracts, Taxpayer now
claims a $s loss deduction. This deduction is for a loss Taxpayer claims it sustained
with respect to the Forward Contracts.

   The Service asserts that the issuance costs offset the amount realized from the

completion of the Forward Contracts. Exam takes the position that issuance costs are
not deductible because they offset the proceeds received from the permanent capital
raised. See McCrory v. U.S., 651 F.2d 828(2d Cir. 1981); Barbour Coal Co. v. Comm’r,
74 F.2d 163 (10th Cir. 1934); Affiliated Capital Corp. v. Comm’r, 88 T.C. 1157 (1987).

    Taxpayer claims that based on the cash settlement analysis in PLR 200450016

the $s in issuance costs allocated to the Forward Contracts can be deducted in TY2 as
a loss. Taxpayer argues that such issuance costs are allowed under section 165
because the issuance costs were incurred to facilitate a stock issuance pursuant to the
Forward Contracts, whereas no stock was actually issued pursuant to the Forward
Contracts. It asserts that the cash settlement analysis does not allow Taxpayer to issue
its stock under the Forward Contracts. As we understand the Taxpayer’s argument, the
issuance costs incurred to facilitate a stock issuance under the Forward Contracts
became a loss when the Forward Contracts were purportedly abandoned. The cash

PRESP-107900-10 5

paid by the investors, the argument continues, was paid pursuant to the Exchange
Offer, which was a separate new contract.

   You asked us whether the section 1032(a) ruling supports Taxpayer’s position

that the issuance costs allocated to the Forward Contracts can be deducted in TY2
because Taxpayer did not issue stock under the Forward Contracts.

LAW AND ANALYSIS

  A.     PLR 200450018

    Revenue Procedure 2004-1, 2004-1 C.B. 1, governed Taxpayer’s 2004 ruling

requests. Pursuant to the Rev. Proc., Taxpayer submitted a proposed transaction, and
based on the form of the transaction chosen by Taxpayer, the Service ruled on the tax
consequences of the transaction that was presented. Thus, Taxpayer chose the form of
its transaction that was addressed in PLR 200450018. Taxpayer stated in its letter
requesting an appeal from the examining agent’s determination, that the National Office
set forth the substance of the transaction as a cancellation of the Forward Contracts for
cash. However, this is Taxpayer’s characterization. The National Office issued the
following ruling: “Company will be paid $i by each accepting Unit holder in settlement of
each Contract. This amount is gain resulting from Company’s receipt of property in
cash settlement of its [Forward] contract to sell its stock . . . .” (Emphasis added.)

    Taxpayer did not raise or discuss issuance costs in its PLR submission or

request a ruling on these costs. Moreover, none of the rulings Taxpayer received in the
PLR address the deductibility of the issuance costs. The rulings focused on the
application of section 1032(a) to the amounts received by Taxpayer in cash settlement
of its Forward Contracts. We note that the ruling letter also did not contain the
background analysis the Service considered in reaching its decision to rule favorably on
Taxpayer’s ruling requests. However, because this analysis is pertinent to the issue
that has arisen over Taxpayer’s issuance costs undertaken pursuant to the Forward
Contracts, we set forth our analysis below.

  B.     Why did the Service apply section 1032(a) to Taxpayer’s gain on the
         Forward Contracts when no stock was issued?

   The Service views the physical settlement and the cash settlement of a forward

contract as economically the same transaction. Section 1032(a) provides that no gain
or loss shall be recognized to a corporation on the receipt of money or other property in
exchange for stock (including treasury stock) of such corporation. Thus, when a
corporation is in a gain position on a forward contract on its own stock and issues stock
to the counterparty in exchange for a payment (“physical settlement”), section 1032(a)
nonrecognition applies to any gain (or loss) from the amount realized from the payment
for such stock. When a corporation is in a gain position on a forward contract on its own
stock, and it does not issue stock because the parties agree to “cash settle”, the

PRESP-107900-10 6

corporation receives a payment from the counterparty, in the amount that represents the
difference between the forward contract price and the value of the shares of stock on
the date of the cash settlement. Section 1032 nonrecognition also applies to the
payment the corporation receives in the cash settlement. The net amount by which the
corporation is ahead is the same whether it issues the stock for the payment or receives
a cash settlement in lieu of issuing stock. In effect, in a cash settlement, the corporation
is deemed to issue its stock at the forward contract price, and immediately buy it back
from the counterparty at the fair market value.

    In the instant case, Taxpayer sought a section 1032(a) ruling because it was in

the gain position on the Forward Contracts and it proposed a cash settlement of its
Forward Contracts. Taxpayer was in a gain position because, in a physical settlement,
Taxpayer would have issued one share of stock worth $o in exchange for a $n payment,
resulting in a $p gain realized. In a cash settlement, investors would make a $p
payment to Taxpayer, which would reflect the $n payment owed less the value of
Taxpayer’s stock. The completion of the Forward Contracts by Taxpayer and the
investors, whether by physical settlement or cash settlement, resulted in Taxpayer
realizing the same amount of gain. The Service did not perceive a reason to suggest
that Taxpayer change the form of its transaction and issue a share of stock for the
section 1032(a) ruling, since the tax consequences under section 1032 were the same
whether Taxpayer physically settled or cash settled the Forward Contracts.

   The Service’s policy that both a physical settlement and a cash settlement of a

forward contract on the taxpayer’s own stock should be treated as a transaction to which
section 1032 applies is based on the notion that the two transactions are economically
the same, and that to treat section 1032 as applying to a physical settlement but not to a
cash settlement would create an opportunity to whipsaw the Service. If the Service did
not apply section 1032 to a cash settlement of a stock sale agreement, including forward
contracts, Taxpayers in a gain position would always physically settle to get
nonrecognition under section 1032, and taxpayers in a loss position would always cash
settle to get out of section 1032 and recognize the loss.

   The Taxpayer’s position in the instant case creates a third characterization of the

transaction and one which, if adopted, would create yet another opportunity for
whipsaw. Taxpayer received a net payment from a cash settlement on the Forward
Contracts and realized gain. The Service ruled the gain realized was not recognized
because section 1032(a) applied. However, Taxpayer now claims that the cash
settlement of the Forward Contracts, pursuant to its Exchange Offer, was a different
contract from the Forward Contracts which the Exchange Offer was settling. It claims
that the Forward Contracts were thus “abandoned”, and the payments from the
investors were received pursuant to the Exchange Offer instead, resulting in a loss
deduction under section 165 for costs allocated to the Forward Contracts.

    However, had the Taxpayer presented as the facts in its PLR submission that it

received the settlement proceeds for some transaction other than the contract to sell its

PRESP-107900-10 7

own stock, i.e. the Forward Contracts, section 1032(a) would not have applied to the
gain. The Service issued the section 1032 ruling in the PLR because it treated the cash
settlement proceeds as payment for Taxpayer’s stock under the Forward Contracts.
Taxpayer’s tax treatment of its costs is inconsistent with its tax treatment of the
proceeds received under the cash settlement. Taxpayer’s position would require the
Service to allow a loss on the same Forward Contracts that produced gain. That
position is internally inconsistent and is not the position of the Service. 2

    C.      Taxpayer’s claimed section 165 loss deduction for costs under the
            Forwards should be disallowed because Taxpayer did not abandon the
            Forwards.

   Taxpayer’s position is that the Forward Contracts were abandoned to pursue the

Exchange Offer. Taxpayer relies on the fact that the Service issued a ruling accepting
the cash settlement form of the analysis in PLR 200450016 to support its position that it
abandoned the Forward Contracts because under the cash settlement form it did not
physically issue stock as originally contemplated under the Forward Contracts. Instead,
Taxpayer’s argument continues, it pursued the Exchange Offer, a different contract,
which allowed it to settle the obligations under the Forward Contracts.

  The Service’s position is that the Taxpayer did not abandon the Forward

Contracts and in fact completed the Forward Contracts via cash settling those contracts.
The Forward Contracts were profitable to Taxpayer and indeed the gains realized by
Taxpayer were the result of the investors’ obligations to Taxpayer under the Forward
Contracts. Taxpayer was paid $p per forward obligation in a cash settlement of the
Forward Contracts. The payments Taxpayer received to settle the Forward Contracts
were a payment of the investors’ obligations under the Forward Contracts, even though
some of the terms were modified in a document Taxpayer labeled “Exchange Offer.”

   Despite the modified terms, Taxpayer received payments based on the same

subject matter (stock), the same counterparties (the investors), and the same referenced
Forward Price. Therefore, Taxpayer received the $p payments pursuant to the Forward
Contracts.

   Section 165 allows a deduction for any loss sustained during the taxable year

and not compensated for by insurance or otherwise. Deductions for abandonment
losses are provided for in § 1.165-2(a), which provides a loss is deductible under §
165(a) if it is incurred in a business or in a transaction entered into for profit and arising
from the sudden termination of the usefulness in such business or transaction of any
nondepreciable property, in a case where such business or transaction is discontinued

2
Although not controlling, the same dilemma could exist when costs are paid to acquire bonds that pay
out tax-exempt income. In such cases, however, the dilemma is resolved by section 265(a), which
disallows a deduction for any amount otherwise allowable that is allocable to income (other than interest)
wholly exempt from the taxes, or any amount otherwise allowable under section 212 which is allocable to
interest wholly exempt from the taxes imposed by subtitle A.

PRESP-107900-10 8

or where such property is permanently discarded from use therein. Accordingly, a loss
is deductible only where the taxpayer has actually entered into a transaction for profit
and the transaction is abandoned. Rev. Rul. 57-418, 1957-2 C.B. 143. Moreover,
under § 1.165-2(b), the provisions for abandonment losses do not apply to losses
sustained on the sale or exchange of property.

    Changes in a transaction do not constitute abandonment. For example, in FRGC

Investment, LLC v. Comm’r, T.C. Memo. 2002-276 (October 31, 2002), the taxpayer, in
1995, entered into a real estate contract to purchase 240 acres for development from an
entity owned by individual. After objections to surveys and other title reports, the
escrow for the contract was cancelled. In 1996, taxpayer entered into a second real
estate contract with the same entity to purchase 404 acres of the same land for
development. Approval for zoning the development became unlikely so, in 1997, the
taxpayer and entity executed mutual cancellations of the contract to release the escrow.
In 1998, the taxpayer and the individual owning the entity that was a party to the first two
contracts decided to execute a third contract. The contract was fulfilled and the escrow
closed that same year, resulting in taxpayer owning the land that it sought to develop.
Taxpayer claimed a section 165 loss for expenses incurred in 1997 arguing the 1997
contract had been abandoned. The tax court disagreed. It found that taxpayer’s claims
that the 1998 contract was different from the purported abandoned 1997 contract was
rebutted by the fact that taxpayer moved forward to purchase the same real estate for the
same purpose, although there had been changes in the terms of the agreement.
Furthermore, the tax court was unwilling to ignore the fact that the contract to purchase
real estate that was allegedly abandoned in fact resulted in the taxpayer owning the
land for development. In the end, the tax court determined that the 1996 contract was
not abandoned in 1997 but was merely a step in taxpayer’s attempts to complete the
transaction aimed at acquiring and developing the land it eventually acquired.

  In the instant case, Taxpayer claims the changes in the method of completing the

Forward Contracts resulted in an abandonment of the Forward Contracts in favor of the
Exchange Offer. The changes do not rise to the level of abandonment of Taxpayer’s
Forward Contracts. Moreover, the transaction culminated in a sale or exchange of
property, a disposition for which the abandonment loss provisions are not applicable.

     A loss deduction is allowed for costs incurred for a transaction when the taxpayer

is left without any value to show for the costs incurred. In Rev. Rul. 79-2, 1979-1 C.B.
98, individual taxpayers were allowed a section 165(c) loss when they abandoned a
public offering of their corporation. The shareholders of M Corporation decided to make
a public offering of some of their combined holdings. During the months prior to the
offering, legal, accounting, registration, and printing fees were paid by the individual
shareholders to make the offering. The offering was postponed due to unfavorable
market conditions and then the shareholders stopped their plan to publicly sell their
stock. The Ruling reasoned that a section 165(c) loss was appropriate because the
public offering became worthless when it was abandoned. In Rev. Rul. 77-254, 1977-2
C.B. 63, the taxpayer, after investigating several businesses to purchase, eventually

PRESP-107900-10 9

decided to purchase a specific business and incurred expenses in an attempt to
purchase this business. Certain disagreements between the individual and the owner of
the business developed and the individual abandoned all attempts to acquire the
business. The Ruling reasoned that costs otherwise capitalized became a loss when the
transaction failed. In the Ruling, Taxpayer never acquired the business and the costs of
that transaction became deductible.

   In this case, Taxpayer was not left without value to show for the costs it allocated

to the Forward Contracts. Taxpayer was left with cash. In fact, Taxpayer received the
same value under the Exchange Offer as it would have under the Forward Contracts (as
adjusted by the amount of the inducement to the investors to settle the Forward
Contracts early). Taxpayer received $p on each of the x# of the Forward Contracts
returned in the Exchange Offer. The Exchange Offer was the same transaction as the
Forward Contracts: Taxpayer was entitled to payment from the investors under each
contract for the same obligation – i.e. the investor’s obligation under the Forward
Contracts to purchase a share of stock. An investor who entered into one Unit with
Taxpayer, had an obligation to buy one share of stock at $n. The investor could have
paid $n for a $o share under the Forward Contract, which would have resulted in a net
value to Taxpayer of $p. Pursuant to the Exchange Offer, investors paid Taxpayer $p,
which became the net result to the Taxpayer. The Exchange Offer merely continued
the transaction started in the Forward Contracts and because the Taxpayer did not
abandon the Exchange Offer but received cash under the transaction, a sale or
exchange occurred and no abandonment loss is appropriate.

   D.     Taxpayer’s argument that the Example under Section 1.263(a)-5 of the
          regulations supports its position is erroneous.

   Taxpayer stated in its appeal letter: “Since the Forward Contracts were settled by

the payment of cash to [Taxpayer] and not by the issuance of stock by [Taxpayer],
[Taxpayer] deducted the …issuance costs allocable to the Forward Contracts under
section 165.” Taxpayer cited to §1.263(a)-5(l), Example 3, in the regulations.

     Section 1.263(a)-5(a) provides that a taxpayer must capitalize an amount paid to

facilitate an applicable transaction. An applicable transaction includes an acquisition of
capital or a stock issuance. §1.263(a)-5(a)(7), (8). Example 3 of §1.263(a)-5(l)
provides facts specifying that a taxpayer incurs costs to evaluate four alternative
transactions and abandons three of the four transactions. The Example concludes that
the taxpayer may recover under section 165 amounts to facilitate the three abandoned
transactions when such transactions are abandoned.

   In citing to Example 3, Taxpayer’s point seems to be that the Forward Contracts

were an abandoned transaction and the Exchange Offer was not, and, thus, the costs
incurred on the Forward Contract are deductible as a section 165 loss.

PRESP-107900-10 10

    However, in the instant case, this Example is not applicable. First, section 263,

by its terms, is not relevant in determining whether a taxpayer has abandoned an asset.
Specifically, a taxpayer must apply the regulations and precedents under section 165 to
determine whether an abandonment has occurred and whether the taxpayer is entitled
to an abandonment loss.

    Second, Example 3 is factually distinguishable from, and has no relevance to

Taxpayer’s situation because Taxpayer’s facts do not involve separate and distinct
transactions, and do not involve an abandoned transaction. The facts in Example 3
present four different possible transactions, between a taxpayer and four different
parties. In our case, there is only one transaction, and one set of parties... Taxpayer
began with Units that consisted of a Forward Contract and a Note, and Taxpayer was
paid under the Forward Contract through a cash settlement, and it paid back the Note
with cash and stock. The Forward Contract was completed and not abandoned. Merely
because Taxpayer labeled the settlement of the Forward Contract as an “Exchange
Offer” in its dealings with the investors, does not have the effect of abandoning the
Forward Contract. The Forward Contract contained the obligations that were the
subject of the Exchange Offer. The investors were in a significant loss position under
the Forwards. The price the investors ultimately paid Taxpayer was based on the
obligations of the investors under the Forward Contracts. The Exchange Offer did not
release the investors from their obligations under the Forward Contracts. The Exchange
Offer provided the investors an inducement, by adjusting the Forward price slightly
downward, to settle the Forward Contracts prior to their maturity. Thus, the
Taxpayer’s facts do not involve the abandonment of a transaction under section 165.

This writing may contain privileged information. Any unauthorized disclosure of
this writing may undermine our ability to protect the privileged information. If disclosure
is determined to be necessary, please contact this office for our views.

  Please call (202) 622-7305 if you have any further questions.