Sec. 163(l)'s "substantial certainty" test and related-party convertible debt.

• Author: Borghino, Jeff

The IRS concluded in Letter Ruling 201517003 that a convertible debt held by a person related to the issuer was subject to Sec. 163(1) only if there was a substantial certainty that the conversion option would be exercised. The letter ruling is noteworthy because it had conflicting facts in determining whether Sec. 163(1) applied. This item summarizes the current law and discusses the facts and conclusion in Letter Ruling 201517003.

Sec. 163(I)

Congress originally enacted Sec. 163(1) in 1997 because it was concerned that corporations could issue debt that more closely resembled equity, for which an interest deduction was not appropriate (Staff of Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 1997, at 193 (the 1997 Bluebook)).

Under Sec. 163(1)(1), no deduction is allowed for interest paid or accrued on a disqualified debt instrument. However, Sec. 163(1) does not affect the characterization of a disqualified debt instrument as debt or equity or the treatment of its holder (the 1997 Bluebook).

A disqualified debt instrument means any debt of a corporation that is "payable in equity," which refers to either: (1) equity of the issuer or a party related to the issuer; or (2) equity held by the issuer or a party related to the issuer. For purposes of Sec. 163(1), a person is related to another person if the person bears a relationship described in Sec. 267(b) or 707(b).

Sec. 163(1)(3) provides that debt is treated as "payable in equity" if a substantial amount of the principal or interest is:

1. Required to be paid in, converted into, or determined by reference to the value of the equity;

2. Payable in, convertible into, or determined by reference to the value of the equity at the option of the issuer; or

3. Payable in, convertible into, or determined by reference to the value of the equity at the option of a related party to the issuer (the related-party option test).

Under Sec. 163(1)(3)(C), a debt is treated as payable in equity if it is part of an arrangement that is reasonably expected to result in one of these circumstances.

In addition, the statute provides that a debt is treated as payable in equity if: (1) a substantial amount of the principal or interest may be required at the option of the holder, or a related party to the holder, to be paid in, converted into, or determined by reference to the value of the equity; and (2) there is a substantial certainty that the option will be exercised (the holder...