Current Options
Disclosure Document
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    FSA Takes Hard Line on Capitalization

August 15, 2001  

A recently issued Internal Revenue Service Field Service Advice should make it more difficult for investors to avoid capitalizing some of the interest expense incurred when they borrow against hedged positions.

FSA 200131015 dealt with DECS (debt exchangeable for common stock), a security that resembles a collar.  Under the facts of the FSA, a corporation issued an instrument under which fixed quarterly payments were made.  At maturity, the instruments would be redeemed for differing amounts based upon the fair market value of the shares of an unrelated corporation (“Corp A”).   If the value of Corp A is less than $X per share at maturity, then the holder of the instrument is entitled to receive one share of Corp A stock for each unit; if the price is between $X and $Y, then the holder is entitled to receive a fractional share of Corp A stock for each unit with a total fair market of $X; and if the price exceeds $Y, then each unit would be exchanged for Z% of a share of Corp A stock.  The issuer has the right to satisfy the instrument with either Corp A stock or cash.

In the FSA the Service reached the following conclusions:

  1. the instrument should not be classified as debt,
  2. the instrument and the Corp A stock do constitute a straddle, and
  3. the fixed quarterly payments are charges incurred to carry the straddle.

The IRS used a very broad definition of the word “carry” in order to conclude that all of the quarterly payments had to be capitalized.   This rationale could cause the interest expense incurred on loans associated with collared stock to be capitalized in most, if not all, cases.  This FSA takes the “hardest line” in applying the capitalization rules, if indeed they do apply.  Other methods for applying the capitalization rules to straddles are possible (see Collar Interest: A Question of Identity). Instead of debating the methods for applying these rules, however, taxpayers may find it more productive to structure their investments so that they do not constitute straddles in the first place.   If the stock and the hedge do not constitute a straddle, then any charges or interest expense would not have to be capitalized.  

If the stock being hedged was acquired prior to 1984, then it would not be subject to the straddle rules, so no special structure would be necessary.

For stock acquired after 1983, Twenty-First Securities has developed a methodology that, we are advised, does avoid the application of the straddle rules.  This approach should increase the likelihood that the interest expense incurred on the borrowing will be fully deductible at the time it is incurred.

For an interactive overview of hedging and monetizing possibilities for different types of appreciated securities, investors can consult Twenty-First Securities' low-basis stock hedging decision tree.

This article and other articles herein are provided for information purposes only.  They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication.  Investors should consult their advisers before acting on any topics discussed herein.

Options involve risk and are not suitable for all investors. 
Before engaging in an options transaction, investors must review the booklet "Characteristics and Risks of Standardized Options".



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