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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:
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the instrument should not be classified as debt,
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the instrument and the Corp A stock do constitute a
straddle, and
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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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