CCA 9952015: Counsel flags bifurcation and dividend deduction questions for stock-linked instrument

Plain-English summary

A company issued an instrument linked to another company's stock, with periodic payments and settlement in cash or stock. Chief Counsel said the field should request further advice on whether the instrument could be split into separate components, including a debt component. Counsel also said a debt-versus-equity analysis was unnecessary to challenge an interest deduction, and flagged a possible dividends received deduction issue under section 246(c). The memorandum says there were not enough facts to resolve the § 246(c)(4) issue and gives no final tax characterization of the instrument.

Ruling snapshot

• Question: How should the stock-linked financial instrument be characterized for tax purposes?
• Outcome: Advice given: explore bifurcation and section 246(c); no final classification was reached.
• Key authorities: IRC § 246(c)(1), (c)(4); Farley Realty Corp. v. Commissioner.

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
I N T E R N AL R E V E N U E S E R V I C E WASHINGTON, D.C. 20224

September 24, 1999
Number: 199952015
Release Date: 12/30/1999
UIL: 9999.98-00
TL-N-3937-99

MEMORANDUM FOR Rodney J. Bartlett, Acting District Counsel CC:SER:IDD:IND

FROM: Deborah A. Butler, Assistant Chief Counsel (Field Service)
CC:DOM:FS

SUBJECT: New Financial Instrument

ISSUE:

What is the proper characterization of a new financial instrument?

LEGEND:

INSTRUMENT A =
COMPANY A =
DATE 1
=
x
=
y
=
z
=

FACTS:

This memorandum addresses the tax treatment of a new financial instrument, INSTRUMENT A, which COMPANY A issued to the public.

INSTRUMENT A was pegged to the value of stock of an unrelated company. INSTRUMENT A, upon maturity or redemption, could be settled either in cash or in the stock of the unrelated company. Holders of INSTRUMENT A would receive quarterly “interest” payments at a rate of x% annually.

DISCUSSION:

We coordinated our response with National Office divisions having subject matter jurisdiction over the issues. The following sets forth the discussions that ensued during a telephone conversation between the field attorney, the examining agent, and National Office attorneys. 2

The National Office attorneys are especially interested in the bifurcation issue inherent in this transaction and believe the field should request Field Service Advice on this issue. Under the bifurcation theory, INSTRUMENT A could be divided into component parts, with the y% coupon being treated as a separate debt instrument. The authority for bifurcating the instrument is Farley Realty Corp. v. Commissioner, 279 F.2d 701 (2d Cir. 1960). We also discussed the substance-over-form line of cases.

The National Office attorneys also noted that a debt/equity analysis does not apply here. In order to deny the interest deduction, we need not determine that the instrument is equity; thus, references to equity in the Form 886-A are not necessary.

We also discussed our belief that there may be a dividends received deduction (“DRD”) issue here. We suggested that sections 246(c)(1) and 246(c)(4)(A) and (B) might be applicable. With respect to section 246(c)(1), we mentioned Duke Energy Corp. v. United States, No. 3:97-CV-40-MU (W.D.N.C. Jan. 15, 1999). Insofar as section 246(c)(4), there are not enough facts to determine whether this is an issue. Nevertheless, it should be explored. Examination had not raised the DRD issue because COMPANY A has held the stock for so many years that the lengthy holding period could preclude denial of the DRD on that basis alone.

Application of the straddle rules was mentioned without an in-depth discussion because the Revenue Agent’s Report on this issue was previously forwarded to COMPANY A.

It was agreed that Examination should proceed based upon the following:

2. 3

3.

4.

5.

By: ______
CAROL P. NACHMAN
Special Counsel
Financial Institutions and Products Branch Field Service Division