Deductibility of loan fees in light of conflicting judicial opinions.

• Author: Castellanos, Anthony R.

In mid-1994, the Tax Court and the Ninth Circuit reached opposite conclusions on whether loan financing fees relating to stock redemptions were deductible under Sec. 162(k). Since this area of the law is unsettled, taxpayers should look closely at the application of Sec. 162(k) in making decisions concerning appropriate tax return filing positions.

Sec. 162(k)

In general, Sec. 162(k) was enacted in 1986 for the purpose of disallowing otherwise deductible expenses incurred by a corporation "in connection with the redemption of its stock." Exceptions are provided in Sec. 162(k)(2) for deductions relating to interest expense allowable under Sec. 163, dividends paid under Sec. 561, and any expenses incurred with respect to stock redemptions by certain regulated investment companies. Examples provided in Sec. 162(k)'s legislative history of the types of expenses applicable include amounts paid to repurchase stock; any premiums paid for such stock; and other expenses such as legal, accounting, brokerage, transfer agent and appraisal fees incurred as part of a redemption; or any expenses so related.

Overview of judicial precedent

The statutory language of Sec. 162(k) that seems to have divided the courts is the phrase "in connection with the redemption of its stock." In Kroy (Europe) Limited, 27 F3d 367 (9th Cir. 1994), it was held that fees incurred in connection with obtaining financing used by a taxpayer to redeem its outstanding stock were capital expenditures associated with the financing arrangements; as such, they could be amortized and deducted ratably over the term of the outstanding loans and debt securities. (This decision reversed a district court ruling.)

In reaching its conclusion, the Ninth Circuit held that the appropriate test to be applied in determining deductibility of loan fees is the "origin of the claim" test (derived from Gilmore, 372 US 39 (1963), and expanded in Woodward, 397 US 572 (1970), and Hilton Hotels Corp., 397 US 580 (1970)). The Ninth Circuit concluded that the origin of the fees was the financing arrangements (i.e., the borrowing transaction) which, while related to the transaction, were "separate and independent" from the redemption transaction. In essence, the court bifurcated the leveraged buyout into separate transactions--the financing arrangement and the stock redemption.

In contrast, just weeks later, the Tax Court ruled, under similar facts, in Fort Howard Corp., 103 TC 345 (1994), that such expenses...